Category Archives: Corporate Earnings


Minimize Risk Without Sacrificing Returns? Sven Tells You How

  • By dissecting the S&P 500 per valuation quintiles we see that only parts of the market are overvalued.
  • Historically, buying the lowest PE quintile stocks has increased annual returns by 360 basis points.
  • High PE stocks have large market capitalizations which force you to own more of them through index funds, increasing your risks and lowering your returns.


Beyond the top news stories about central banks increasing stimulus to fight the BREXIT or sluggish economic data with high hopes for the future, there is one recurrent theme that still flies under the radar. The recurring theme is that financial markets are overvalued.

As we all know, bull markets climb a wall of worry. Investors who sold everything in 2011 believing markets were overvalued were happy for a while, but are probably still crying now as, if they had not gotten back in the market, they missed a huge upside. We might be in a similar situation where selling now would mean losing much upside, but there is another option.

Figure 1 S&P 500 last 10 years
Figure 1: S&P 500 chart for the last 10 years. Source:

Today we are going to discuss the alleged market overvaluation and dissect it into overvalued and undervalued segments. This is possible as the market is currently all over the place. We are going to end with an example of potential irrational exuberance, social network stocks, and show how such investments can be avoided even when allowing for a high level of diversification.

Dissecting Market Overvaluation

The PE ratio of the S&P 500 is 25.24 if you calculate it by using S&P 500 earnings. By changing methodology, you can get to other averages, but we believe this one to be the most accurate as it looks at aggregate earnings and not stock PE ratios with a lot of negative inputs that skew the result. The average PE ratio for all S&P 500 stocks with negative ratios included ends up at around 19, so don’t get confused by the difference.

In any case, the expected returns with a PE ratio of 25.24 are below 4% per annum, and as corporate earnings are not growing we cannot expect much more. If you hold a diversified ETF or mutual fund that tracks the market, you can’t expect more than 4% returns in the long run, but you should be able to lower your risks and even increase your long term returns if you choose not to include irrationally overvalued companies in your portfolio.

Of course, complete S&P 500 diversification is then out of the question, but here is why. When buying an index, the most expensive stocks have the largest weights because as they get more and more expensive, their market capitalization increases and the fund manager is forced to buy more, which further increases the price and forces the asset manager to buy even more creating a vicious circle that leads into irrational exuberance.

But by looking at quartile valuations of expected forward PE ratios, we see that the market is overvalued only within the highest PE quintile.

figure 2 quintile expected forward PE
Figure 2: S&P 500 PE ratios by quintile. Source: Smead Capital Management.

As historically stocks with the lowest PE ratios have outperformed all other groups, we can limit the risks of a market downturn by shifting our portfolios towards low PE ratio stocks. Those who did that in the last 40 years achieved above market returns of 360 basis points (market average 11.7%, lowest quintile PE stocks 15.3%).

figure 2 PE ratio returns
Figure 3: Returns by valuation quintile. Source: Smead Capital Management.

To give some research aid, here are the 25 S&P 500 stocks with the lowest PE ratios. Be careful because low PE ratios don’t always mean high earnings. Special events like divestitures or future imminent costs can skew PE ratios.

CompanyTickerPE Ratio
Delta Air Lines Inc.DAL3.87
Noble Corp.NE6.44
Yahoo! Inc.YHOO6.64
Valero Energy Corp.VLO7.03
American International Group Inc.AIG8.91
Assurant Inc.AIZ9.42
Danbury Resources, Inc.DNR9.50
Unumprovident Corp.UNM9.59
Deere & Co.DE9.69
Travelers Companies Inc.TRV9.94
CF Industries HoldingsCF9.94
Lincoln National Corp.LNC10.04
Ford Motor Co.F10.23
Hess Corp.HES10.36
International Business Machines Corp.IBM10.39
Verizon Communications Inc.VZ10.48
Lyondellbasell IndustriesLYB10.52
Masco Corp.MAS10.55
Murphy Oil Corp.MUR10.69
Chevron Corp.CVX10.72
AT&T Inc.T10.88
Capital One Financial Corp.COF10.91
Allstate Corp.ALL10.92
Goldman Sachs GroupGS10.95
Figure 4: S&P 500 lowest PE stocks. Source: The Online Investor.

Digging into such a list can give you companies that have stable businesses and low valuations despite any market whim.

High Valuation Example

Not taking anything away from Facebook (FB) or giving any investment analysis, we are going to use it as an example of how a high PE ratio stock can influence our long term investment.

FB’s current weight in the S&P 500 is 1.53% which means that the average Joe that only invests in the S&P 500 has 1.53% of his portfolio in FB. This might be a good thing as FB has had an extraordinary performance since its IPO, but it also means you are paying $125 a share for something that has a book value of $17.54 and EPS of $2.09.

FB will probably continue on its growth path in the future, but investors must understand such a situation carries more risk and the risk can be explained with the huge fall other social networking stocks have witnessed.

figure 5 FB LNKD
Figure 5: Facebook’s, Twitter’s and LinkedIn’s performances in the last 4 years. Source: Yahoo Finance.

LinkedIn has fallen from a price of above $250 per share at the end of 2015 to a price near $100 earlier this year due to lower growth. It was saved by Microsoft which bought it for $26.2 billion, or $196 per share.

Twitter didn’t find any suitors, so its price is still 55% below IPO.

Any change in FB’s growth trajectory, which is bound to arrive sometime as no corporation can grow forever, can have a LinkedIn effect on Facebook which will mean that half of the 1.53% of one’s portfolio would be wiped out.

Another example of high PE ratios and low returns could be Microsoft which bought LinkedIn despite the company not being profitable. Microsoft’s PE ratio is currently around 28 which puts it into the higher valuation quartiles. Microsoft’s weight in the S&P 500 is 2.41%.


The main message of this article is that you can choose where to be invested and you can minimize long term risk and, from an historical perspective, you do not even have to sacrifice your returns. By buying the stocks that are suitable to your investing goals you can achieve better returns and avoid the market risks you don’t like. Those can be social networking stocks, money-losing car makers, or oil companies. Because in order to have a well-diversified portfolio, you only need about 20 stocks.

figure 6 portfolio risk
Figure 6: Number of stocks needed in order to eliminate market risks. Source: Investopedia.

As index funds are created for long-term investors that want to be well diversified, if you want something other than that, you can lower your risk and achieve better returns by buying stocks that have higher earnings as in the long term, stock returns and earnings are perfectly correlated.


Signs of Fragility in the Economy Point to an Impending Bear Market. What To Do Now To Protect Yourself.

  • The last jobs report was good news but it also indicates higher costs and full employment.
  • An “easy to hire, easy to fire” mentality is in the air.
  • Healthcare, cash or short term trades should be the best options in this situation.


Last week the Nasdaq and S&P 500 reached yet another record high. Aggressive central bank stimulation pushes investors to disregard risks and look for any kind of yield or growth. Not looking at risk is the worst thing an investor can do, but they also shouldn’t fight the trend.

Even from a long term perspective the market is irrationally valued, and no one can know how long it will stay that way. Being in cash might seem logical but a 0.1% return looks much worse than the S&P 500’s 8.9% year-to-date return.

Today, we are going to analyze earnings as 86% of S&P 500 companies have reported them, but first take a look at Friday’s jobs report which sent mixed signals.

The Jobs Report

On Friday, the U.S. Bureau of Labor Statistics reported an increase in total non-farm payroll employment of 255,000 in July. The unemployment rate was unchanged at 4.9 percent which is great news for the economy but not so much for investors because it indicates that we are close to full employment. The unemployment rate has stabilized at 4.9% and wages have started to increase (2.6% over the year). Higher wages mean higher costs which have a negative effect on margins and earnings.

figure 1 unemployment rate
Figure 1: Unemployment rate. Source: Bureau of Labor Statistics.

Apart from the reach of full employment and higher wages, the fact that businesses prefer to hire more than to invest in equipment signals that corporations are not so optimistic about the future. They easily hire but know that they can fire with the same ease, if necessary. If you buy equipment, you are stuck with it in most cases.

figure 2 employment equipment
Figure 2: Lower equipment spending in favor of labor. Source: Bloomberg.

The “easy to hire and fire” effect is even more pronounced by the increase in the number of people forced to work part-time for economic reasons, which rose from 5.84 million to 5.94 million.

All of the above means that job numbers are fragile and can quickly shift in the opposite direction. This, along with slow GDP growth, will probably keep the FED on hold or result in minimally increased rates to hold off inflation.

S&P 500 Earnings

The second quarter of 2016 is the fifth consecutive quarter with a decline in earnings.

figure 3 earnings growth
Figure 3: S&P 500 earnings growth rate. Source: FACTSET.

The S&P 500 reported sales were flat in comparison to Q2 2015 which means that the increased hiring does not create growth but is necessary to merely keep up with the competition.

Analysts have postponed expected earnings growth to Q4 2016, which doesn’t mean much as they had expected earnings growth for this and for the next quarter. So, as always, analysts’ expectations have to be taken with a grain of salt.

From a sector perspective, consumer discretionary was the best performer with earnings growth of 10.7% which is logical seeing that consumer spending is the only growth segment of the U.S. GDP. But as consumer discretionary is not essential, any kind of bad news or tightening credit might quickly turn this trend around.

For investors interested in not taking on much risk if a bear market hits us, the healthcare sector continued its good news. Healthcare earnings grew 4.9% and revenue grew 9%. As we know that the global population is getting older, especially in the developed world we can expect demand for healthcare to stay stable, or fall the least in a recession or bear market. Therefore, finding good healthcare investments is essential for a defensive portfolio that is still open to growth in this bull market but limits the potential downside if things take a turn for the worse.

figure 4 sector
Figure 4: S&P 500 Earnings growth by sector. Source: FACTSET.

All other sectors are exposed to negative volatility because consumers are going to save on all things except for food and healthcare. With oil prices around $40 we cannot expect an earnings pickup in the energy sector.

The most important factor for long term investors is valuation. Lower earnings and higher prices have brought the current S&P 500 PE ratio to 25.25. If the FED is forced to increase rates due to high employment rates, corporate earnings will be further pressured downwards by the high debt levels and tightening credit will lower consumer spending.

figure 5 multpl
Figure 5: S&P 500 PE ratio continues to grow. Source: Multpl.


We are in a situation where the S&P 500 is consistently breaking new highs while there have been 5 consecutive quarters of declining earnings, slow GDP growth, lower productivity and where bank credit, the main factor for GDP growth, is about to tighten due to increased interest rates and full consumer indebtedness.

We cannot know for how long such a surreal situation will last, but as smart investors we have to be prepared for the worst and still try to grasp the benefits of the upside. As Warren Buffett has $66 billion in cash on his balance sheet, we might to also want think about having cash on hand just in case a bear market comes that will enable us to buy the bargains. As earnings yields are at 4%, that would be the opportunity cost for holding cash but we can hold cash for 5 years and still break even if a bear market comes along. It is difficult to mentally accept such a strategy as we are in the 7th year of this bull market, but some returns have to be sacrificed in order to lower risks.

Another option for diversification is to use a part of your portfolio for well-placed short term trades. The S&P grew minimally in the last two years but in the meantime it gave great trading opportunities. With stop losses and by knowing what you are doing, you can limit the time you are invested, thus lower the risk of being caught in a bear market while still creating healthy returns on the liquid part of your portfolio.

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Corporate Earnings of the S&P 500’s Top 10: Why It Is Important for You

  • Corporate earnings and fundamentals are variable, pick the stocks that best suit you.
  • There are low PE ratio stocks, high growth stocks, and high dividend yielders – anything you might want.
  • But be aware: some companies engage in buybacks that are detrimental to shareholders’ value.


When you add up the top ten companies by weight, they account for 17.7% of the total weight of the S&P 500. For investors who are heavily invested in the S&P 500, following the earnings of its top ten companies is essential in order to understand the risks and rewards of being invested in the index. In this article we are going to assess the current market situation by looking at what has been going on with the 10 biggest companies in the S&P 500 index.


Apple (Nasdaq: AAPL) reported earnings after hours on Tuesday. Q2 2016 revenue declined 14.4% year-over-year and earnings per share declined 27% to $1.42 from $1.85. Those results were better than expected, and AAPL jumped 7% in after-hours trading.

AAPL isn’t a standard company, its revenue is highly dependent on iPhone sales which fell due to customers awaiting a new generation iPhone to be announced in September. If the same trend holds true as it has in the past with new iPhone generation sales, AAPL’s sales will increase when it releases the new phone. In the meantime, perhaps the most important thing from this earnings report is the fact that AAPL returned $13 billion to investors through dividends and repurchases.

The dividend yield is 2.38% annually but when we add in the repurchases, it comes to a staggering 2.3% quarterly yield, making AAPL’s dividend yield quite a bit higher than the S&P 500 average of 2.05%.

In total, the S&P 500 buybacks were $161 billion in Q1 2016,—interestingly, Apple alone makes up about 8% of this total— second only to Q3 2007 when the buybacks reached $172 billion. The most important thing with buybacks is the question: is buying your own stock the best use of cash at that point in time? Yes, companies protect and increase their share prices, but at what cost? We all know what happened in the two years after Q3 2007 when repurchases reached record highs…

Another company that is strong in repurchases in Microsoft (Nasdaq: MSFT).


MSFT also saw its revenue decline, by 6%, and earnings per share declined 23% (GAAP results), but nevertheless returned $2.8 billion in dividends and $3.6 billion in repurchases, giving a dividend yield of 2.54% and a 3.1% indirect yearly repurchase yield.

The decline in revenues and earnings further exacerbates the above mentioned buyback issue, but even more alarming is the fact that MSFT is buying its stock despite their PE ratio of 27.7, while AAPL’s is at 11. This is where alpha kicks in because good stock picking can make you avoid such bad cash investments.

Exxon Mobil

The consensus earnings per share for Exxon Mobil (NYSE: XOM) is $0.64 for Q2 2016 which is 34% below the earnings per share in the same quarter last year.

XOM’s share repurchase program is another crazy example of ill-timed purchases. In February, XOM stopped its buyback program after spending $210 billion over the last decade. The craziness lies in the fact that the company has stopped buying back stocks despite the price being at multiyear lows.

figure 1 xom buybacks
Figure 1: XOM’s stock price movement in the last 2 years. Source: Yahoo Finance.

This falls perfectly in line with what usually happens as managers time buybacks poorly. When stocks are cheap, management doesn’t buy them. When they are expensive, buybacks explode, eroding shareholders’ value.

figure 2 total buybacks
Figure 2: Quarterly share repurchases and number of companies repurchasing shares. Source: FACTSET.

Johnson & Johnson

Johnson & Johnson (NYSE: JNJ) is continuing on its wonderful ascent despite revenues and earnings per share not growing since 2014. JNJ has a $10 billion share repurchase program that is being financed by debt. The current enthusiasm is of course backed by global monetary easing which pushes future expectations higher.

General Electric

General Electric (NYSE: GE) has survived terrible times in the last 7 years. GE’s revenue is currently just 64% of its 2008 revenue, but the company finally managed to increase earnings and revenue in the last quarter. The PE ratio is still high at 24, and J.P. Morgan warns that GE will face bad times again due to the volatility in the economy and other internal issues.

Amazon and Facebook

Amazon (NASDAQ: AMZN) and Facebook (NASDAQ: FB) have the growth that the companies discussed above are missing, but it comes at crazy valuations.

AMZN’s PE ratio is 303, while FB’s PE ratio is 74.5. We cannot know if AMZN will manage to grow its earnings by more than tenfold in order to reach a more normal valuation or if it will forever stay the mega growth company.

Holding the S&P 500 gives you diversification, the unfortunately you gain exposure to companies after their initial growth cycle has passed. AMZN’s weight in the S&P 500 was only 0.46% in 2009 when its price was about a tenth of its current price.

Berkshire Hathaway

Berkshire Hathaway (NYSE: BRK.A, BRK.B) hasn’t yet release its earnings but what is significant and different from the above companies is that buybacks are limited. BRK will buy back its own stocks only if the price falls below 1.2 times book value. Warren Buffett believes that buying back the company’s own shares above book value is a disservice to shareholders. This might be one of the reasons why BRK has by far outperformed the S&P 500 in the last 30 years.

figure 3 brk vs sandp
Figure 3: BRK vs the S&P 500. Source: Yahoo Finance.


AT&T (NYSE: T) doesn’t have comparable earnings as it recently acquired DirectTV, however it is a company that keeps on growing, has a high dividend yield of 4.53%, and has had minimal share repurchases when compared to other companies in the last 4 quarters.

JPMorgan Chase & Co

The last company on our list is JPMorgan Chase & Co (NYSE: JPM). JPM reported revenues up by 4% and net income up by 5%, and has a PE ratio of 10.87 with a price to book ratio of 1.0, making it the company with the best fundamentals on our list and a great introduction to our conclusion.


Most great investors would advise the average investor to hold the S&P 500 for the long term, but the analysis of the 10 companies we’ve discussed and the variety of their revenue growths, earnings, and management buyback policies suggest something different.

Being long the S&P 500 just because that’s what everyone else does means also having managers destroy shareholder value by excessive and poorly timed buybacks, or it means paying high valuations for companies with no growth or exorbitant valuations for growth companies. On top of that, the risks of just owning the S&P 500 are increasing as its valuation is higher and is at levels only seen twice historically, in the dotcom bubble and just before the 2009 crisis.

figure 4 s&P 500 pe ratio
Figure 4: S&P 500 PE ratio. Source: Quandl.

Investors should assess their own needs and financial requirements. There are plenty of relatively safe high dividend yielders on the market, value companies, growth companies and declining companies from which to build your portfolio.



As The S&P 500 Reaches New Highs, Asset Inflation Continues

  • All factors are indicating an artificially created asset inflation.
  • Earnings are expected to decline with economic outlook being constantly revised downwards.
  • Gold is gaining alongside stocks which confirms that all assets are inflated.


Amidst all the turmoil from BREXIT, negative interest rates and global downward economic growth forecasts, the S&P 500 has reached a new high. On Monday it closed at 2,137.16 points, overtaking the previous high of 2,130.82 from May 21, 2015. The Monday record was surpassed again on Tuesday and Wednesday, with Wednesday closing at 2,152.43.

figure 1 s and p 500
Figure 1: S&P 500 in the last 5 years. Source: Bloomberg.

This new high isn’t significant in terms of real returns as the market hasn’t really gone anywhere in the last 14 months, but it is significant from a psychological and confidence perspective. In this article we are going to look for the breakout reasons and fundamentals, and analyze potential risks.


It’s pretty straightforward: if earnings grow then the S&P 500 is also supposed to grow, if earnings decline and the S&P 500 grows we can assume we are in a bubble. At the moment, earnings are not growing and this earnings season will probably be the fifth consecutive quarterly earnings decline. In total, net income is down 18% since its 2014 high.

figure 2 earnigs
Figure 2: S&P 500 index and earnings. Source: Bloomberg.

The 18% decline isn’t that bad when compared to the average 36% earnings decline in recessions since 1936, but currently we are not even close to being in a recession.

Investors seem optimistic and willing to pay a hefty premium for stocks. The current S&P 500 PE ratio is approaching 25 and it has been higher than 25 on only two occasions in the last 100 years, in the dotcom bubble and in the midst of the Great Recession when earnings plunged.

figure 3 S&P 500 pe ratio
Figure 3: S&P 500 PE ratio. Source: Multpl.

As earnings are not growing and fundamentals are deteriorating, there must be something else that creates investor optimism.

Economic Data

As stock prices reflect future expectations, a look at GDP forecasts will give a good perspective on the rationality of the above valuations. In June, well before the BREXIT vote, the World Bank lowered its global growth forecast from 2.9% to 2.4% indicating more trouble for corporations. The International Monetary Fund has cut its forecast for the U.S. from 2.4% to 2.2% for 2016 but expects a pickup to 2.5% in 2017, while the FED expects moderate and stable economic growth at 2% for the next few years. In greater detail, the media highly promoted the 287,000 new jobs added recently but failed to focus on the increased unemployment rate from 4.7% to 4.9%.

One might wonder if the above mentioned data is enough to sustain a PE ratio of 25 as historically the economy has grown faster than 2% and the S&P 500 has had lower PE ratios, again an indication that asset prices are inflated.

Low Bond Yields 

The inflation in asset prices is especially visible in fixed income investments. With 30% of global sovereign debt charging a negative yield, investors push bond prices higher and higher in a desperate search for positive yields. This is further enhanced by the central banks of Europe and Japan actively buying corporate bonds on the market, and even stocks for the latter. As long as central banks relentlessly continue buying securities, it is very difficult for stock markets to experience substantial declines which means that small risks are being smoothed out by monetary policies while the big black looming risk grows bigger and bigger.

Not only that, but capital flows toward fixed income funds are reaching record highs.

figure 4 etf flows
Figure 4: Cumulative fixed income ETP flows in billions. Source: Bloomberg.

S&P 500 Sector Performance

One could argue that the above mentioned corporate earnings decline is mostly the result of lower commodity prices and declining earnings in the energy sector, but only 4 of 10 sectors will see earnings growth in the coming earnings season.

figure 4 earnings per sector
Figure 5: S&P 500 expected earnings growth per sector. Source: FACTSET.

Despite that the energy sector is expecting the worst decline in earnings, its performance in the last 6 months has been the best as things have stabilized a bit. On the other hand, the fact that utilities, energy and materials were the best performing sectors in the last 3 months shows that investors are looking for investments that protect against inflation and have constant, recession-proof yields.

figure 5 sector spdr
Figure 6: S&P 500 sector performance in the last 6 months. Source: Sector SPDR.

The same conclusion related to the search for inflation protective assets can be reached by the looking at the continuing surge in gold prices.

figure 6 gold prices
Figure 7: Gold prices in the last 12 months. Source: Bloomberg.

Gold is usually not correlated with stocks, but from the chart above we can see that both gold and stocks are increasing which again leads toward the conclusion that all asset prices are inflated.

What To Do

It is difficult to be smart in such an artificially created situation, but stock picking and “stick to what you know” might be the best option. You must evaluate the companies in your portfolio and identify how they will perform in the uncertain times that are ahead as asset inflation, possible real inflation in the future, and higher rates will wreak havoc among securities.

Now is the time to be smart. Investors should grasp the opportunities given by the high liquidity but at the same time think of the potential risks if anything changes in the current financial monetary easing system.



Prepare for Earnings Season: Prices, BREXIT, GDP & Trends

  • This article provides a list of companies whose earnings will be affected by the BREXIT.
  • The dollar is stable thus we should not expect strong global currency effects.
  • The probability of U.S. recession has hit an 8-year high which should be detrimental for earnings in next two years.


In the long term, stock returns are perfectly correlated with the underlying earnings and therefore the upcoming Q2 2016 earnings season is very important. Positive earnings could push the markets to new highs while bad news could indicate the start of a recession or bear market.

In this article we are going to discuss how to prepare yourself by analyzing various factors that influence earnings.

Factors That Will Influence Earnings

To come to the best possible estimations, we are going to analyze commodity prices, currency swap rates and general economic trends.

Currency Effects

As more than 30% of S&P 500 revenues comes from abroad, currency translation effects are very important to analyze, especially now after the BREXIT.

figure 2 usd gbp
Figure 1: USD per 1 GBP in last 12 months. Source: XE.

The British pound has fallen 10% in relation to the dollar which means that all the assets, revenues and profits from the UK are now 10% lower than they were two weeks ago. This is the reality, but then there is accounting that will try to tell you various stories.

The impact on earnings will depend on the way a company accounts for its overseas assets and revenues. Companies that use the current rate method (i.e. the rate on the last date of the financial statement) will be immediately affected, while companies that use the temporal method (i.e. the historical rate at the date assets were bought) will not show the complete impact of the BREXIT in their statements.

Companies that get more than 15% of their revenues from the UK are Molson Coors (NYSE: TAP), BlackRock (NYSE: BLK), and eBay (NASDAQ: EBAY). Other companies that are also exposed are Apache Corporation (NYSE: APA), Transocean (NYSE: RIG) and ConocoPhillips (NYSE: COP) in the oil sector, and Invesco (NYSE: IVZ), E*Trade (NASDAQ: ETFC), Morgan Stanley (NYSE: MS) and Citigroup (NYSE: C) from the financial sector. Investors with those companies in their portfolio may want to check the accounting policies so they won’t be surprised by bad news in the upcoming financial reports.

All in all, the dollar index was even a bit weaker than in Q1 2016 and equal to its Q2 2016 level, so investors shouldn’t be worried about currency issues, with the exception of the UK exposed companies listed above.

figure 3 us dollar index
Figure 2: U.S. dollar index. Source: Bloomberg.


Average oil prices in Q2 2015 were around $60 per barrel while average oil prices in April 2016 were $37.86, May $43.21 and June $50, which is an average price of $43.69.

figure 1 oil prices
Figure 3: Average monthly oil prices. Source: Statista.

No matter the story presented by companies, trailing earnings will be severely hit and year-on-year comparisons will be negative as the price of the product they are selling is 28% lower than in Q2 2015. Long term investors should not be fooled by the growth in relation to Q1 2016 as oil prices are 50% higher, but traders can seize short term opportunities given by the positive short term trend.

Other Commodities

Gold stocks should see a nice boost to their earnings as gold prices have surged since March. Iron ore miners should also have positive news as iron prices were in the $55 to $60 trading range compared to the $40 to $45 in the two previous quarters. The same holds for copper, zinc and nickel prices.

In the fertilizer sector, prices continue to be around historic lows so investors should not expect a rebound. Ammonia prices are reaching new lows, and urea prices are at multi-year lows. The same is true for UAN prices and potash, but things might change in the next quarter as Canadian potash producers started to cut back on production.

General Earnings Trend 

The general earnings scorecard doesn’t look that good. S&P 500 earnings are expected to decline by 5.3%, and this decline will mark the fifth consecutive earnings decline.

figure 4 earnings and S&P 500
Figure 4: Earnings and S&P 500. Source: FACTSET.

As earnings have stopped growing, the S&P 500 has also stopped growing which only reinforces the theory that in the long term, stock returns are perfectly correlated to underlying earnings.

The 5-quarter decline in earnings growth suggests companies have reached their earnings limit in the normal economic cycle with low interest rates keeping asset prices high. In such an environment, bad earnings surprises are not uncommon and could have a negative impact on the market. Of the S&P 500 companies that issue guidance, 81 have issued negative guidance for Q2 2016 and only 32 positive EPS guidance.

The Economy and Longer Term Earnings Perspective (One Year)

The declining earnings indicate that companies have reached their earnings limit due to fierce competition. The artificial environment created by low interest rates makes everybody succeed and brings down margins. Even though no one likes it, a recession would be great as it would root out the weeds. According to Deutsche Bank, the probability of a recession in the U.S. in the next 12 months has hit highs not seen since 2008.

figure 5 us recession
Figure 5: Probability of U.S. recession in the next 12 months. Source: Deutsche Bank.

As earnings have been declining for 5 quarters, it is logical that investments will be lower which is exactly what is happening.

figure 6 business investments
Figure 6: Domestic business investments. Source: St. Louis FED.

Lower business investments should keep up earnings for a while but are detrimental to earnings in the long term.


The picture is pretty clear. Investors should focus on the geographical market of their respective investments and try to assess currency impacts before earnings are disclosed, especially for UK exposed companies.

In the long term, the high probability of a U.S. recession combined with 5 quarters of declining earnings indicates that the risks are higher than the rewards and investors should position themselves accordingly in the next two years.


Don’t Be Fooled by Noise, Earnings Will Tell the Truth

  • A look into next month’s earnings season and trends.
  • 6 out of 10 S&P sectors have earnings declining.
  • 72% of companies issued negative guidance.


With all eyes focused on Brexit and the FED, it seems that no one really cares what is going on in the economy and, most importantly, with corporate earnings. Don’t forget that next month is earnings season and the earnings trend up until now has been a negative one. As corporate earnings are the main factor in stock returns, you should be focusing on how to prepare for that and not on Brexit as it will probably be forgotten by next week.

Many believe that predicting corporate earnings is not possible, but thanks to the multitude of data constantly published, it does not seem impossible. It just takes a lot of work and analysis.

This article is going to analyze sector-by-sector news in order to estimate the upcoming earnings season results.

Corporate Earnings

The main thesis behind bearish market views is that corporate earnings have been steadily declining for the past two years.

figure 1 Sand P earnings
Figure 1: S&P 500 earnings. Source: Spindles.

The little uptick in Q1 2016 was mainly due to commodities prices rising and smaller losses in the energy sector, but is still below Q1 2015 which marks five consecutive quarters of year-over-year declines in earnings. The main influence in the above decline comes, of course, from energy and materials, but don’t be fooled by that as 6 out of 10 S&P 500 sectors had earnings declining for an average decline of 6.7%.

figure 2 earnings by sector
Figure 2: S&P 500 earnings growth by sector. Source: Factset.


Energy earnings are easy to predict as they are related to crude oil and gas prices. Stocks usually follow those prices, so it is difficult to get a significant prediction here.

figure 3 energy earnings
Figure 3: S&P 500 energy earnings. Source: Spindles.

As crude oil and gas prices have been on average much higher than in Q1 2016, we should not expect negative surprises in the sector, but earnings will be again lower than Q2 2015.

figure 4 crude oil
Figure 4: Crude oil in last 12 months. Source: Bloomberg.


The story with materials is similar to the one for energy as prices have rebounded a bit but are still far below Q2 2015. The metal price index shows how the subdued commodity prices are not rebounding that fast and it will take a longer time for the lower margins to eliminate higher cost production.

figure 8 metal prices
Figure 5: Metal price index. Source: index mundi.

This slump in commodity prices is going to keep material earnings depressed and far below the averages of the last 5 years but as the below figure shows, the industry is cyclical both in the long and short term, so traders could grasp the opportunities given by the high volatility and long term investors can buy the excellent low cost commodity producers at low historical prices.

figure 5 materials
Figure 6: S&P 500 materials earnings. Source: Spindles.

Consumer Discretionary, Information Technology and Healthcare

Consumer discretionary, information technology and healthcare were the bright lights of Q1 2016 with earnings growth but this is about to change as the majority of companies issued negative guidance.

figure 6 guidance
Figure 7: Number of S&P companies with positive and negative guidance by sector. Source: Factset.

Of the 113 S&P 500 companies giving guidance, 81 have issued negative guidance while only 32 have issued positive EPS guidance.

A good example of how earnings can be predicted is by looking at car sales. Automotive companies have low PE ratios as everyone expects a decline in sales but the decline is not coming. Car sales have fallen by 7.4% year-over-year but this has been covered by increases in minivan sales.

figure 7 car
Figure 8: U.S. car sales. Source: Wall Street Journal.

For those interested in particular automotive companies and monthly sales, a site to watch is Motor Intelligence. For example, General Motors witnessed a 5% yearly decline in sales which is going to have a very negative effect on earnings while Ford managed to increase sales by 4% in the U.S. for the same period.

Longer Term Earnings Expectations

Analysts are always positive as they are mostly employed by investment banks and whose goal is to pump asset prices in order to gain more on commissions. Therefore, analysts will always see declines as just temporary and base their estimations on the rosiest scenarios. The current trend sees declining corporate margins but analysts expect this trend to turn around immediately.

A good way of debunking this assumption is to compare the current analysts’ estimations with the same from a year ago.

figure 9 analysts estimates margins
Figure 9: Current analysts’ S&P 500 corporate margins estimations. Source: Factset.

Analysts’ estimates from the same period last year were much rosier than what really happened and it is difficult to expect margins improving with full employment negative guidances.

figure 10 estimates last year
Figure 10: Analysts’ S&P 500 corporate earnings estimations from last year. Source: Factset.

The current profit margin is 9.7% while last year analysts estimated a profit margin of 10.6% for this period.


Corporate earnings can be partly estimated for subsequent quarters as lots of data—like car sales or retail trends—are publicly available on a monthly basis. By tracking such indicators an investor can minimize the risks of being caught up in a stock amidst a negative earnings surprise. As in the longer term there are many factors that can lower or increase earnings like the strength of the dollar, Chinese demand or oil prices, no one can know what will happen but can assess the probabilities of something happening and the effect on a portfolio.

The current trend is a negative one showing no strong improvement signs as commodity prices are still subdued. The economy is reaching full employment which should increase operating costs, and buybacks are not that profitable for companies as they are paying high prices for their own shares.



There is a Huge GAP Between Reported and GAAP Earnings

  • Real earnings are currently 25% lower than pro forma reported ones.
  • The other consolidated income statement can also hide surprises.


How would life look if things were as you saw them or exactly like someone presented them? Surreal for sure as it would require a non-human mind to objectively process information and accept a situation as it is. People usually fall in love with the wrong person or feel depressed over nothing important. The same is applicable in business, but it’s strongly biased toward falling in love with one’s business and refusing to see the flaws of it. Such a behavior results in a large gap between pro forma reported earnings and official Generally Accepted Accounting Principles (GAAP) results.

Investors have to be mindful about that when analyzing earnings, and must precisely determine what the real situation is compared to managements’ rosier view. Even Buffett touched on the subject in his last letter to shareholders warning that “it has become common for managers to tell their owners to ignore certain expense items that are all too real” and analysts are part of the culprit as they propagate misleading numbers that can deceive investors.

Gap Between GAAP and Pro Forma Earnings is Widening

Pro forma figures exclude certain items that are considered by management as non-recurring. Some of those expense items include the costs of laying off workers, legal costs, acquisition expenses, cost of stock-based compensation, expenses related to asset volatility, asset write-downs, effects of foreign-currency moves, omitting results from newly opened and recently closed stores and depreciations not related to current operations. By eliminating noise, management’s intention is to present earnings related to the core business as what is happening around it is of no importance. The best way to explain what is going on is to let you read yourself. Apache Corporation (NYSE: APA) reported the following in its annual report:

For the year ending 2015, Apache reported a net loss of $23.1 billion, or $61.20 per diluted common share. On an adjusted basis, Apache’s 2015 loss totaled $130 million, or $0.34 per share. Net cash provided by continuing operating activities was approximately $2.8 billion, and adjusted EBITDA was $3.9 billion in 2015. Total capital expenditures were $4.7 billion for the full year, or $3.6 billion when excluding leasehold acquisitions, capitalized interest, Egypt noncontrolling interest, and spending on divested LNG and associated assets. This was at the low end of the company’s full-year 2015 guidance range of $3.6 to $3.8 billion.

APA’s management managed to turn a loss of $23 billion into an adjusted loss of $130 million and even finish with positive adjusted EBITDA of $3.9 billion. It is practically impossible for an investor not specialized in accounting to understand what is real and what not in such an annual report. Unfortunately, APA is not an exemption in the corporate world but more of a new mainstream.

1 figure gaap and pro forma

Figure 1: Gap between pro-forma and GAAP earnings widening. Source: The Wall Street Journal.

The official GAAP S&P 500 earnings in 2015 were $787 billion versus pro forma estimates of $1.04 billion which means that 25% of expenses are not treated by management as expenses but as mere non-recurring items. It is the widest difference since 2008 and a closer look shows that S&P 500 real GAAP earnings have not increased by 0.4% like pro forma earnings show, but instead declined by 12.7%. The issue is not only related to smaller companies like the above mentioned APA, but also to blue chips. 18 of the 30 Dow Jones Industrial Average (DJIA) members have reported higher pro forma than GAAP earnings.


Figure 2: DJIA average year-over-year change in EPS. Source: FACTSET.

Even blue chips report higher earnings than real earnings, and companies have had a history of treating the ordinary as extraordinary when business conditions worsen. In 2014, the difference between GAAP and pro forma earnings was 11.8% while in 2015 it jumped to 30.7% for the DJIA companies that report pro forma earnings.

3 difference 2014 2015

Figure 3: Difference between (%) pro forma and GAAP earnings for DJIA stocks. Source: FACTSET.

The most notable example from the DJIA is Merck (NYSE: MRK), who reported 2015 GAAP EPS of $1.56 and pro forma EPS of $3.59. The difference, according to management, comes from acquisition and divestiture related costs, restructuring costs and legal fees. The funny part is that in 2014 they excluded the same costs to form pro forma earnings and also forecast 2016 GAAP EPS to be between $1.96 and $2.23 while pro forma reported earnings are expected to be between $3.6 and $3.75. It seems illogical to name costs that occur year after year non-recurring.

Other Comprehensive Income

Another accounting issue that is not so much discussed about in the media is other comprehensive income (OCI). OCI includes revenues, expenses, gains, and losses under both GAAP and International Financial Reporting Standards (IFRS) that are excluded from net income on the income statement and are therefore listed after the income statement. Those items are mostly items that have not yet been realized and might change in the future. For example, an investment in a foreign country and currency is affected by currency fluctuations when the value is translated into the home currency. One year it can have a positive effect while the other a negative effect, therefore those differences are kept in the other comprehensive income statement until realized.

Items included in OCI and excluded from the income statement usually are:

  • Unrealized holding gains or losses on investments that are classified as available for sale.
  • Foreign currency translation gains or losses.
  • Pension plan gains or losses.

Before investing, it is good to take a look at accumulated OCI in order to see if the company has some huge unrealized future risks or benefits. Unfortunately the risks and unrealized losses are always wider than unrealized gains.


A good note for the average investor is that the SEC is looking at the issue and probably is going to regulate the way companies report earnings in order to limit the deceiving of investors. But, in the meantime, each investor should meticulously study the pro forma, GAAP and OCI earnings in order to estimate his investment. To conclude, Buffett applauds companies that report OCI income in the regular income statement and only real GAAP earnings.



An Analysis of the Latest Earnings Reports

  • “Sell in May and go away” doesn’t sound so foolish anymore.
  • The Dow Jones Industrial Index average revenue has declined by 4.1%.
  • High liquidity and employment enables buybacks and pension funding that keep the market at high levels.


Recently there have been some surprising earnings debacles. This article is going to elaborate on them and discuss possible reasons and consequences of the earnings misses.

Summary of Earnings

Apple (NASDAQ: AAPL) reported Q2 EPS at $1.9, missing analysts estimates by $0.1 and a revenue decline of 12.8%, also missing estimates. It guided to lower Q3 revenue of $41-$43 billion which is also below estimates of $47 billion.

In spite of declining revenue AAPL continues its buyback program and increased it from $140 billion to $175 billion. By buying its own shares, AAPL is investing in a company with declining revenue and earnings instead of focusing on growth and development. Only the future can tell if AAPL will manage to turn things around and increase revenue or the buyback strategy is the only plausible strategy for AAPL’s management in order to increase EPS. In the meantime, AAPL’s shares were down 9% after the release.

Alphabet Inc. (NASDAQ: GOOG) also missed expectations with revenue growth of “only” 17.4% y/y and EPS of $6.02. GOOG spent only $2 billion on buybacks in the last quarter. Not much when compared to AAPL’s $6.6 billion for buybacks and $2.9 billion for dividends. The above represent two different strategies and focuses. GOOG’s shares were also down 7.3% after earnings.

Another company in the digital world that has seen shares plunge soon after the earnings release is Netflix. Netflix (NASDAQ: NFLX) reported revenue growth of 24.8% y/y and positive earnings per share but the slower than expected growth in subscribers influenced a 15% stock price decline.

The same happened to Twitter (NYSE: TWTR), revenue grew by 36.4% but shares declined by 9.2%. Microsoft (NASDAQ: MSFT) was also down 10% after earnings.

Before moving away from the digital sector, I’ll mention that the S&P 500 was mostly flat while the above companies sustained large losses.

In the financial sector Bank of America (NYSE: BAC) has seen revenue decline by 8% and earnings in-line. American International Group (NYSE: AIG) posted a loss of $1.1 per share but nevertheless increased buybacks by $5 billion and increased its dividend by 14%. Goldman Sachs Group (NYSE: GS) reported a decline of 55% in earnings and a 40% decline in revenue.

The above earnings reports and management actions do not create a positive sentiment. The digital companies like NFLX or social platforms like TWTR are still growing but at a slower rate, the oldies like AAPL and MSFT are not growing anymore and the financial sector is also facing strong headwinds.

In order to see how the market is doing in general—and not to focus on the companies mostly analyzed in the news—a good representation of the market is the Dow Jones Industrial Average Index (DJIA). The below table shows quarterly revenue growth from the 30 companies that constitute the DJIA.

company data

Table 1: DJIA revenue growth per company.

Of the 30 companies in the DJIA 5 companies still have to report earnings and 12 have reported declining revenues, while of the 13 reporting revenue growth only 6 of them have seen revenue grow at a rate above 2.2%. The average revenue decline was -4.1%. With such a strong decline in year on year revenues a similar decline in the Dow Jones index would not be surprising. But what is surprising is that the DJIA has risen 1.8% in the two weeks of the earnings season.

dfow index

Figure 1: DJIA index in the last two weeks. Source: Yahoo Finance.

A reason for the DJIA rising could be that the IRA contributions deadline was on April 15. As the US employment rate is still high and the interest rates are low there was plenty of liquidity to fund pension contributions and consequently the stock market.

unepmloyment rate

Figure 2: US unemployment rate. Source: Bureau of Labor Statistics.

But with declining corporate revenues, management might focus on cost efficiency by laying off employees. Up until now, corporate revenues have been constantly increasing and the consequence was increased hiring. The opposite should happen if the revenue growth trend reverses as the first indications show.

sp 500 sales

Figure 3: S&P 500 Revenue. Source: Multpl.

The previous decline in corporate revenues from the 2008-2009 period had a severe influence on the unemployment rate bringing it up to 10%. Also it was a sharper decline in revenues than the current one, accompanied by a stronger decline in earnings and without quantitative easing.


The high market liquidity influenced by low interest rates enables companies to finance themselves cheaply and reinvest that money into buying their own shares and thus skewing real ratios. A low unemployment rate means that contributions to pensions and financial institutions are high and those can keep the market up, even with revenues declining. But, the declining revenues make the following rule of thumb an interesting perspective:

Sell in May and go away.

FBN Securities researched on how the unwritten rule performed in the last 20 years and the results show that the above rule is surprisingly accurate.

sell in may perfromance

Figure 4: S&P performance by month. Source: FBN Securities.

Returns on being long in May are negative while returns related to the colder months of the year are very positive. As it is very difficult to time the market and very easy to be wrong when selling in May, the above rule of thumb should be taken with a grain of salt. But, seeing that revenues are declining, and declining revenues will eventually have an impact on the economy, it might not be a bad idea to rethink portfolio allocations and risk exposures.