1Q earnings. This time it’s different.

So here we are smack dab in the middle of earnings season for the recently completed first quarter. The conversation about earnings at present is going to be different from the usual topics, e.g., which companies are beating their estimates, which sectors are outperforming or underperforming, etc. Instead, we are going to take the magnifying binoculars we use to get granular and focus on the short term for earnings and turn them around to see through longer-term lenses. And finally, we will connect the longer-term earnings trends to our current positioning and recent Capital Markets Forecast (CMF), The wheat from the chaff: obstacles and opportunities.

Earnings momentum has been slowing and increasingly appears to be a broader problem than something localized in a few industries. In recent quarters, a great deal of attention was paid to the companies that lost revenue as a result of the massive plunge in energy prices and subsequently reported significant earnings drops. In many cases, the problem spread to their credit ratings and led to downgrades, which have made matters worse as they confront higher borrowing costs. First-quarter results for this year, however, are bringing to light sluggish earnings growth in a number of other sectors.

So what is going on?

Back in October, Strategas Research Partners noted several problems that seemed to be creeping into the earnings picture—some of which were an offshoot of possibly nearing the “end-of-cycle” environment. Included in the problems it listed were such items as increasing labor costs, moderating cash flow generation, and rising cost of capital as more debt is used to finance activities. We have even seen elements of financial engineering as buyback programs reduce the number of shares outstanding to help boost per share results.

Then there were also problems seen as characteristic of the overall pattern in earnings growth during this cycle. In relation to these, Strategas noted, “the economy remains largely devoid of the organic drivers necessary for growth to reaccelerate.”¹ In our opinion, this covers a host of sins, many of which date back to the financial crisis. When the financial crisis hit in the fourth quarter of 2008, earnings fell as one would expect, with S&P 500 companies recording a net loss. What was truly remarkable was how quickly they recovered. By the first-quarter end of 2009, the collective red ink had disappeared, with overall earnings returning to levels seen prior to the collapse of Lehman Brothers the previous September.

Why was the last financial crisis different from all others?

This time around, business leaders were well connected to their operations through computerized networks that gave them a quick picture of what was happening to their businesses, which in turn enabled them to quickly respond by cutting costs or production to keep inventories from inflating. Businesses were able to deftly resize their operations and return to profitability in short order. But in so doing, most companies focused on their cost structures. This opened the door to a recurring issue with this recovery which has been the lack of top-line, or gross, earnings growth. As companies have faced these shortfalls, adjustments to the cost structure have been able to keep earnings moving ahead, but we are beginning to wonder if this path still has legs.

The inability to grow top-line revenue has also been reflected in the generally paltry economic growth rates we have been dealing with since the financial crisis ended in March of 2009. Nominal GDP (not adjusted for inflation) has grown by only 3.7% per year since 2009, a rate that is well below historic norms and has helped to keep earnings growth in check.

Finally, we want to point toward productivity growth. Ultimately, “organic” economic growth will reflect productivity growth, which will in turn help to power earnings. The elements of cost cutting and balance sheet manipulation that can help in the short run are no match for the benefits provided by productivity enhancements. As we look to Figure 1, we can see that the productivity story mirrors the relatively sad saga of earnings and economic growth. A period of relatively strong growth accompanied the expansions in the 1990s and early 2000s but after a brief pop as the economy came out of the financial crisis (shaded area in the chart), the path of productivity improvements has taken a distinctly slower pace. For productivity growth to take off, we often need to see technological advances. Certainly this was the case in the 1990s as big advances in personal computers, networks, and the Internet dramatically changed the way we work. Technology has continued to move forward as more computational power is now literally sitting in the palm of our hands with today’s smart phones. However, the productivity numbers have not advanced and the reason for this is probably found in the post-crisis business environment, which has tended to shy away from risk taking and has seen a formidable growth in government regulations.

Figure 1
Productivity continues its slow growth
Organization for Economic Co-operaton and Development

We close by bringing this discourse on earnings back to our current investment positioning and to our long-term thinking in our CMF. There we noted that the U.S. was likely to remain a global leader in growth but we felt that the overall growth rate would remain weaker than historic levels. Given the patterns we are seeing in earnings and productivity growth, we think that this line of reasoning makes sense as the stimulants to higher “organic” growth seem unlikely to appear. After a frantic first quarter that saw markets trade dramatically in both directions, we have arrived at a point where a breakout in economic growth and earnings seems necessary to take the next steps forward. As we have outlined above, we remain skeptical of whether or not this will take place, which has pushed our current positioning closer to our benchmarks as we survey the situation for clues on which direction the markets may take next.

¹ “Market Catechism,” Strategas Research Partners, October 9, 2015

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Market statistics
As of April 22, 2016


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INDEXES

Barclays Aggregate Bond Index
Formerly the Lehman Aggregate Bond Index, this index tracks investment-grade bonds traded in the U.S.; the securities are weighted according to their market size.

Citigroup Economic Surprise Index
A measure for various regions, which shows how economic data are progressing relative to consensus forecasts of market economists. The weighted, historical standard deviations of data surprises are calculated daily in a rolling three-month window. A positive reading suggests economic releases have on balance been beating consensus estimates.

Dow Jones Industrial Average
Index that shows how 30 large, publicly owned U.S. companies have traded during a standard trading session in the stock market.

HFRX Global Hedge Fund Index
One of the family of 75 HFRX Hedge Fund Indexes, the global industry standard for performance measurement across all aspects of the hedge fund industry.

MSCI EAFE Index
Largely recognized as the preeminent benchmark in the U.S. to measure international stock performance; it comprises indexes that represent developed markets outside of North America: Europe, Australasia, and the Far East.

MSCI Emerging Markets Index
Designed to measure stock market performance in the global emerging markets; it covers over 800 securities across 23 markets and represents roughly 13% of world market capitalization.

NASDAQ Composite Index
Index of common stocks and similar securities listed on the NASDAQ Stock Market Index, which has over 3,000 components. The Composite is considered an indicator of stock performance for technology and growth U.S. and non-U.S. companies.

Quality ratings
Used to evaluate the likelihood of default by a bond issuer. Independent rating agencies analyze the financial strength of each rated issuer. Moody’s ratings range from Aaa (highest quality) to C (lowest quality). Bonds rated Baa and better are considered “investment grade.” Bonds rated Ba and below are “speculative grade” or “high yield.” Similarly, Standard & Poor’s ratings range from AAA to D. Bonds rated BBB– and better are considered “investment grade” and bonds rated BB+ and below are “speculative grade.”

Russell 1000 Index
Measures the performance of the large-cap segment of the U.S. equity universe. It represents approximately 92% of the U.S. market, is a subset of the Russell 3000 Index, and includes approximately 1,000 of the largest securities based on a combination of their market cap and current index membership.

Russell 2000 Index
Measures the performance of the small-cap segment of U.S. stocks and is a subset of the Russell 3000 Index, which encompasses the 3,000 largest U.S.-traded stocks.

Russell 3000 Index
Measures the performance of the largest 3,000 U.S. companies representing approximately 98% of the investable U.S. stock market.

Russell Midcap Index
Measures the performance of the mid-cap segment of U.S. stock and is a subset of the Russell 1000 Index. It includes approximately 800 of the smallest securities based on a combination of their market cap and current index membership.

S&P 500 Index
U.S. stock market index based on 500 large companies’ market capitalization (total value of the outstanding shares); widely regarded as the single-best gauge of large-cap U.S. stocks.

S&P Municipal Bond Index
A broad, market value-weighted index that seeks to measure the performance of the U.S. municipal bond market.

WTI, or West Texas Intermediate
A classification of sweet, light (low-density) crude oil from Texas, used as a major worldwide benchmark for oil prices.

 
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