Earnings and revenues can't diverge forever: James Saft

Just about halfway through the U.S. third-quarter corporate reporting season and we find that 59 percent of S&P 500 companies have beaten their earnings estimates, down a bit from last quarter but still an upbeat number.

 

And yet about 60 percent have missed their sales targets, meaning that corporate America is somehow extracting more profit than promised despite bringing less money into the tills than expected.

 

That's admirable, but perhaps a bit disturbingly close to magical.

 

On many readings, all is rosy in the land of equities. Not only does the market have crucial support from central banks bent on forcing money into risk assets (and hoping some of the profits get spent), earnings are at record highs and the amount investors will pay for a share of those earnings is going up.

 

Analysts are forecasting fourth-quarter earnings to grow at a near 9 percent clip, down from the 17 percent they were penciling in earlier but still enough to take the earnings of the S&P 500 to almost $27 per share, in what would be yet another record.

 

And next year analysts are looking for growth of about 12 percent. That optimism, combined with quantitative easing fever and complacency over the euro zone, has allowed price-to-earnings multiples to expand, and not just in the United States.

 

On a global basis, forward-looking P/E valuations have gotten richer since early June, according to Morgan Stanley analysis, most notably for companies in mining, materials, energy and even finance.

 

That's all well and good, but very hard to square with the increasing number of companies saying they haven't been able to deliver promised growth in revenues. The huge majority of S&P 500 companies giving revenue or earnings guidance for the coming quarter have guided downwards, according to data from FactSet.

 

Third-quarter revenue for chemicals company DuPont dropped 9.2 percent from the year-before quarter, to $7.4 billion, below the $8.15 billion analysts expected, a miss the company blamed on global drops in demand. DuPont slashed its full-year earnings estimate to between $3.25 and $3.50 a share from about $4.20 before.

 

Similarly, farm and construction equipment maker Caterpillar Inc lowered its forecasts for the second time in a year, citing economic weakness and uncertainty.

 

WHERE'S THE GROWTH?

 

So, we have a trend towards lower revenue growth, a dwindling number of companies beating expectations and yet a world in which investors see this combination as growing in value.

 

In some ways this is reminiscent of the housing market in the middle years of the last decade, where prices, year after year, outpaced wage and income gains. The argument then was that incomes would soon catch up and that housing was cheap on a financing basis.

 

Housing, of course, was brought down with a thump when people finally worked out that the two numbers - cost and the amount of money available to service the debt backing that cost - could not forever drift further apart.

 

So it may prove for shares.

 

Surely some of the growth of earnings is a credit to company managers, who are proving unrelenting in wringing efficiencies from corporate structures, allowing for earnings growth even in challenging times.

 

Earnings are, on some level, an opinion. There is art to it as well as just math. Think about a bank which values assets and that drives earnings: those marks are ultimately subjective. While earnings may be more or less than meets the eye, a dollar in revenues is always a dollar.

 

Try this: compare earnings on an economy-wide basis and compare to overall economic output. On this measure, corporate America does not have a lot of room to expand its share of the pie, because earnings as a percentage of GDP are at near-record highs and are about half as high again as the kinds of figures we saw in most of the past 50 years.

 

The upside is, if the growth of earnings is confirmed over time by growth in the economy, this would send money flooding into corporations and allow for equity prices to rise even more relative to earnings. That, of course, depends on the fiscal cliff, the euro zone, China and any number of other tough-to-call macro issues.

 

The downside, of course, is that earnings revert to mean in terms of their share of overall output. When you track U.S. wages against profits, you see where most of the expanding share is coming from.

 

It may well be, especially if the government is not going to become much more leveraged, that profits will be limited by wage growth within a context of low overall growth. That particular scenario is only an outside chance, but one which would cause a big fall in shares.

 

Ultimately, the pie is going to have to grow for equities to hold their ground, much less gain more.

 

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft )

 

(James Saft is a Reuters columnist. The opinions expressed are his own)

 

(Edited by Chelsea Emery)

Election Proving a Cliff-Hanger for the Dollar

This year's presidential election in the U.S. is probably the most important in years, not only for the U.S. economy but also for the dollar.

The outcome on Nov. 6 will dictate who will be in the White House for the next four years, how much power he will have to resolve the country's immediate and long-term fiscal problems and whether the U.S. will lose the key triple-A rating that has made the dollar a safe haven for many years.

The market's focus on the election will be even more intense as it comes as the economy continues to struggle out of recession, after a couple of previous false starts, and as a way to prevent the reversal of previous tax cuts due to take place on January 2, 2013--the so-called fiscal cliff--has yet to be found.

Now, it is all in the hands of the U.S. electorate.

The problem for financial markets is that the election is becoming too close to call, with the latest polls showing the Democrat incumbent Barack Obama neck and neck with his Republican opponent Mitt Romney.

This in itself is starting to pose a threat to current market stability, especially if the final vote is too close to allow an immediate declaration and negotiations on the fiscal cliff have to be delayed even further.

As President Obama's previous attempts to resolve the issue with a Republican-led House of Representatives have shown over the last year, the issue is highly divisive and unlikely to lend itself to a quick resolution.

For financial markets, and the U.S. economy, probably the best near-term solution would be either a clear victory for Mr. Romney, keeping the House with him, or a clear victory for President Obama. In either case, that would probably mean at least a short-term extension of the existing tax cuts while negotiations on a longer-term solution take place.

But given the state of current polls, other, more messy, results are more likely. President Obama could be returned to the White House, retaining the status quo of a Democrat majority in the Senate and a Republican majority in the House. Or, he could lose the Senate as well and face an even more implacable task trying to reduce the tax cuts for the very rich.

Similarly, a close result with Mr. Romney in the White House but no backing in the Senate would reduce the chances of swift progress.

Whichever, the chances of a tax-cut extension will be considerably smaller and the U.S. economy could find itself falling over the infamous fiscal cliff.

A protracted stand-off between the White House and Congress would not only introduce fresh uncertainty to financial markets but bring new fiscal tightening to a U.S. economy that is already very fragile.

How this affects the dollar could prove difficult to predict. For much of this year as the global, and U.S., economies have stumbled, the dollar has remained relatively firm as investors have preferred safe havens.

But the dollar's role as one of these havens could well come under threat if the political uncertainty in Washington continues to threaten the U.S. recovery and if concern about the country's longer-term ability to deal with its gigantic deficits starts to undermine investor confidence.

Rumors once again surfaced this week that Fitch would remove the country's triple-A credit rating, a move that could make U.S. assets less attractive than they appear now, although Fitch said its rating is unlikely to change before late 2013.

Hints of what could come were already evident in U.S. Treasurys, where an auction of seven-year paper this week proved the weakest since 2009.

And there's still more than a week to go until the election.

(This is an opinion column by Nicholas Hastings, who is a Senior Correspondent in London for Dow Jones Newswires and has written about foreign exchange for more than 20 years. He previously covered a variety of markets, including equities, fixed income, commodities and energy. He can be contacted on +44-20-7842-9493, by email at nick.hastings@dowjones.com or on Twitter @NickHastingsDJ)