The Earnings Cliff Is Cause for Concern

 | Nov 20, 2012 | 10:00 AM EST  | Comments
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This commentary originally appeared at 9:53 a.m. EST on Nov. 19 on Real Money Pro -- for access to all of legendary hedge fund manager Doug Kass's strategies and commentaries, click here.

Last Monday, in a long series on cliffs, I addressed the economic, tax, fiscal, political and geopolitical cliffs.

I explained why I felt the fears associated with those cliffs were overblown and that the market could rally over the balance of the year.

I did, however, stipulate that I was still fearful of the earnings cliff, which will likely constrain the market's upside (albeit, possibly to higher levels for the S&P 500).

And there is nothing that I saw in the third-quarter reports that reduces my concerns:

  • 95% of the companies in the S&P 500 have reported third-quarter results.
  • Third-quarter 2012 EPS rose by 0.5% (above the consensus, which was down by 2%), but company share buybacks added about 1% to reported EPS. So, EPS before buybacks were actually -0.5%.
  • Excluding financials, S&P earnings per share were -1.6%.
  • 65% of S&P companies exceeded consensus forecasts, down from 69% a year ago. (The long-term average of beats is 60%, and the average beat since the Great Recession has been 74% over the past three to four years.)
  • In third quarter 2012, 25% of the S&P reported worse-than-expected EPS vs. 22% a year ago. (The long-term average is 19%.)
  • Third-quarter 2012 sales growth was a paltry +1.2%, as only 27% of the companies beat consensus while an outsized 54% missed expectations.
  • Profit margins slipped modestly in the third quarter.

To summarize, third-quarter 2012 sales growth fell about 0.8% less than consensus, and third-quarter 2012 EPS growth (year over year) was about 1.5 points above expectations (excluding financials). Profit margins are still 200 basis points above trend line and should continue to trend lower in the face of punk revenue growth.

The top-down consensus for the S&P 500 is for 2013 EPS of $108, and bottom-up consensus is $113 -- both these numbers are clearly way too high.

Most strategists on the Street live at about $103-$105 a share, which, from my perch, is too high as well.

I expect that profit margins will begin to mean revert in 2013 and that S&P earnings will disappoint and will likely fall in the $95-$100 a share range next year.

Fears of an earnings cliff are not overblown. While I believe the S&P can rise to 1410-1430 by year-end, a weakening profit trend could cap the upside to the U.S. stock market in early 2013.

It's the earnings, stupid.

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