A Deeper Dive Unearths the Ugly

 | Jan 23, 2013 | 12:00 PM EST  | Comments
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This commentary originally appeared at 8:04 a.m. EST on Jan. 23 on Real Money Pro -- for access to all of legendary hedge fund manager Doug Kass's strategies and commentaries, click here.

Let's take a deeper dive into the profit and sales progress, or lack thereof, in the three months that just ended.

Fourth-quarter 2012 EPS have slightly beaten consensus expectations, but most of the beat has been due to better numbers in the financial sector. Financials have dominated the earnings reports so far, as they are typically early reporters.

Excluding results in the financial sector, S&P 500 EPS (benefiting from share buybacks) are flat year over year. Adjusted for share buybacks, net income has come in slightly lower (-0.5%).

Of the 67 companies in the S&P that had reported as of Friday night, 26 were financials. Nearly two thirds of reporting companies have beaten consensus compared to about 62% a year ago. About 20% have had negative surprises relative to consensus vs. 27% a year ago.

In terms of sales for reporting companies (excluding financials), they are lower at -0.5% year over year. While 42% of the reports (excluding financials) have beat on revenue, 51% have disappointed relative to the consensus on sales. I expect the trend in disappointing revenue to surface in the first half of this year.

In terms of profit margins (excluding financials), margins are down slightly from fourth quarter 2011.

So far, the U.S. stock market has disregarded and has been disconnected to what is essentially flat profits, slightly weaker margins and a lower revenue backdrop. Sometimes the demarcation between progress and fantasy gets disconnected in the markets, and this might be such a time.

Importantly, if the remainder of the S&P comes in at consensus, fourth-quarter 2012 profits should be +3% in the aggregate, but excluding financials only +1%. Taking out buybacks, it means that net income is essentially flat year over year.

Quarterly S&P earnings have been between $25 a share and $26 a share since third quarter 2011, and I find it difficult to see an upside breakout in the quarters ahead (which would be required to reach top-down 2013 consensus), as both fiscal and monetary policy will be a governor to economic and profit growth in the U.S. in 2013-2014. Indeed, I see downside risks to S&P earnings to slightly below the recent range.

A slowly growing domestic economy is now exposed to the cruel blows of fiscal restraint. The resolution of the U.S. cliff will provide about $700 billion of fiscal drag in the next decade. With the payroll tax holiday expiring on Dec. 31, 2012, about $100 billion-$125 billion will be deducted from aggregate disposable income in 2013. Some states (notably California) instituted a large retroactive income tax increase (let's call it the Phil Mickelson Tax).

Finally, tax increases to finance the Affordable Care Act also went into effect on Jan. 1, 2013. All of these amounts to a fiscal drag of more than 2% of GDP spread over the next 12 to 18 months. Unfortunately, there is more drag ahead, reflecting the Budget Control Act of 2011, which dictates about $110 billion a year of sequestration over the next decade if Congress cannot agree on spending restraints.

Of course, there is a chance that addressing the budget will again be kicked down the road. In theory, policymakers could relieve the aforementioned fiscal drag by repealing or ignoring the Budget Control Act, but this would have other, unintended consequences to the fixed-income markets. As well, entitlement reform (which is long-term in nature) could be agreed to, eliminating the need for a sequester, but the growing animosity in Washington will likely preclude this from occurring.

There is also the chance that the private sector will recover rapidly enough to offset the fiscal drag. On that score I remain skeptical, as the recent regional PMIs indicate 2013 started with a manufacturing slowdown. Meanwhile, macro deleveraging is still incomplete. Moreover, the consumer, facing tax headwinds, appears spent-up, not pent-up. Check out cautionary remarks by Coach (COH, "a transtion year") in Women's Wear Daily, which suggests this morning's earnings release from the company could disappoint. And even the much-heralded housing recovery, despite its broad multiplier impact, seems too small a percentage of GDP (3%) to offset the other constrictive factors.

Expansive monetary policy, too, is likely no longer going to provide a tailwind to growth based on the recent distribution of the Fed minutes that the four-year asset purchase program could be coming to an end over the next 12 months.

All in all, I continue to see potential economic risks to the downside, providing still another hurdle for corporate profits (the mother's milk of the stock market) to meet rosy expectations.

My baseline expectation (of slightly below $100 a share) envisions first half 2013 coming in slightly below the range of the last five quarters, as the fiscal drag begins to take hold at a time when corporate pricing power is imperiled. Margins have held up relatively well, but we must continue to be vigilant in monitoring prices paid, labor costs, inflationary and raw materials pressures and interest rates, among other factors influencing margins.

The bottom line is that while 2013 consensus S&P profits (top-down) are about $107 a share, I expect a more challenging earnings landscape in the year ahead, with $100 a share or even less more likely to be closer to actual results.

Should $100 a share turn out to be actual 2013 S&P profits, down from $101-$102 projected in 2012 and consensus of $107 a share, the expectations of higher stock prices over the balance of the year will rest chiefly on a revaluation upward in P/E multiples (from nearly 15x today).

I continue to argue (so far incorrectly, at least measured by the market performance) that while 15x is in line with the last five decades of valuations, it is not undemanding given the secular headwinds to growth around the world described recently in "A Wolf in Sheep's Clothing." These include:

  • an aging market and economic advance;
  • unsustainable fiscal policy;
  • the earnings cliff that is upon us;
  • the interest rate cliff that may lie ahead;
  • the uncertainty of a reallocation out of bonds into stocks;
  • Washington does not instill confidence;
  • a spent-up, not pent-up, consumer;
  • diminishing policy alternatives; and
  • volatile valuation.

In summary, despite money flows providing a continued and persistent rise in stock prices since year-end (let's call this The Tepper Liquidity Argument), the earnings and revenue cliffs are growing more visible, at least to this observer.

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