The quiet of a pre-Christmas Friday allowed me to do some real research. While waiting for the release of FactSet's weekly Earnings Insight piece published by John Butters and his team, I went back to an old source from a Wall Street legend, Ed Yardeni. His daily chart book is available here.
The three key takeaways from Dr. Yardeni's research are:
U.S. stocks are overvalued today and, at 18.3x forward earnings estimates, are reaching the P/E-based resistance level that predated 2018's poor index performance.
Earnings estimates for 2020 are entirely too high, making the "real P/E" -- by my figuring, not Dr. Yardeni's -- almost exactly 20x.
Profit margins have peaked for this cycle, and the margin improvement implied by 2020 consensus estimates that show S&P earnings growing almost twice as fast as revenues is completely fantastical.
It is true that there has always been (in my 27 years of following the markets, anyway) a downward bias to earnings estimates in any given quarter or annual period. I was a sell-side analyst for 11 years and I know all about the "underpromise/overdeliver" game of setting earnings estimates. That said, there is no way on God's green Earth that S&P earnings will grow 9.1% next year. On Dr. Yardeni's figures S&P 500 earnings grew at only 1.1% in 2019 (based on I/B/E/S estimates; theFactSet figure is closer to 0.0%) and what possible reason would there be for an earnings acceleration next year?. A trade "deal" that effectively maintained tariffs versus China at current levels? As the kids would say, that's wack.
So, in the midst of a Santa Claus/short-squeeze rally, it seems that no one pays attention to these "minor" details. They are not minor. I am fully aware that the Fed has pumped an astonishing $377 billion into the economy by expanding its balance sheet since Labor Day. Yes, it's QE4. Only Powell and his FOMC cronies would deny that.
The question, though, is whether that incremental money flow actually makes its way into profits of Corporate America. Here Dr. Yardeni uses an indicator that I have never seen published anywhere else, it is a damn good one.
Using the reported revenues from S&P and the reported operating profit from I/B/E/S, Dr. Yardeni creates a mixed-ingredient operating profit margin for the S&P 500 that is amazing. The figure for the third quarter of 2019 was 8.5%, representing a surprisingly steady decline since its peak in late 2012 at 11.5%.
Yet, his second measure of profitability, an after-tax measure that is based on profits reported to the IRS (which includes depreciation and inventory deductibility) sits at 12%, down slightly from the recent peak of 12.5% last year, but a full three percentage points higher than its value in late 2012.
So, how can Corporate America's capital-adjusted after-tax profit margin have improved by three percentage points in the same time period in which Corporate America's operating profit margin has declined by three percentage points? It's all about Big Tech, balance sheet manipulation and Trump's tax cuts.
As Facebook (FB) workers wipe the dust and grime off after clocking out after an 8-hour day...OK, it doesn't work like that. The FAANG companies have very little inventory and depreciation, because none of them -- including Apple (AAPL) , which offshored virtually all its production years ago -- actually MAKE anything.
So, reported EPS gives a wildly distorted version of the true profitability of these companies and measures that are supposed to take into account capital usage (EVA, for example) are completely worthless since these companies consume so little capital per dollar of revenue. Because they don't make anything, compensate their employees through newly-issued shares and don't pay dividends (except in Apple's case, but Apple also aggressively buys back AAPL shares, ) the FAANG companies as a whole are net producers of capital, not consumers.
So, the bottom line is to focus on the operating profit line, and not the bottom line. The market is paying more and more for fewer units of operating earnings. It's damn expensive to hire an engineer right now in Silicon Valley, and given the costs of living in the Bay Area, those costs are only going to rise. But those costs are expensed, not capitalized, and that shows up in lower operating margins.
So, lower interest rates and higher equity values actually hurt the FAANG companies, not help them. No, that's NOT true of GM (GM) , GE (GE) , Boeing (BA) , Exxon Mobil (XOM) , and US Steel (X) (which is cutting its dividend,) but when was the last time you read anything about those companies? It's all FAANG these days, and every one of those companies, especially Amazon (AMZN) , is facing major operating margin pressures as we head into 2020.
Hence consensus estimates that show S&P earnings growing at 9.1% on revenue growth of 5.1% fundamentally ignore the changes happening in the U.S. economy. With so little trading time left in 2019 it is unlikely the market reacts to that quickly, but I am looking forward to a particularly intense confession season as we enter the earnings reporting period in January 2020.