Accounting Games Hide Deteriorating S&P 500 Earnings

Includes: DIA, IVV, SPY
by: John Early

Cost-cutting that boosts operating earnings may actually be reclassifying and hiding expenses rather than reducing costs. In order to make the number or beat the estimate, a company might during the reporting season choose to reclassify some line of business with poor results as not an ongoing operation. Then those expenses do not have to be reported as operating earnings. The results are still included as as-reported earnings. This would explain why in recent reporting periods estimates of operating earnings went up, while estimates for as-reported earnings fell.

This pattern of recent quarters where operating earnings stay strong, while as-reported earnings falter, preceded the big earnings declines in 2000-02 and in 2007-09. The chart below shows both operating earnings (in black) and as-reported earnings (in blue) for the last three complete quarters. The darker lines show the results after all companies had reported earnings. The lighter lines show the Standard & Poor's estimated earnings for the quarter prior to any company reporting. The operating earnings were higher than the estimates by a few cents, while the as-reported earnings ended dollars below the estimates.

Click to enlarge images.

The second quarter of 2012 is the most dramatic. During the summer as the financial media was reporting a robust proportion of companies beating estimated operating earnings, the measure of earnings that includes all the expenses was getting hammered. When all results were in, operating earnings beat the estimate made before earnings season began by 24 cents. In contrast, as-reported earnings fell $4.47 below the estimate of $26.09.

As of Standard & Poor's last update, dated Nov. 15, 2012, 96.3% of the companies in the S&P 500 have reported third-quarter earnings. The estimate of as-reported earnings has fallen significantly over the last two months.

There appears to be a tendency for companies who will have the worst results to wait late in the period to report earnings, perhaps hoping to avoid the hoopla in the prime part of earnings season. Or at least this is my supposition for why estimates of as-reported earnings falls so much toward the end of the reporting period. Between Nov. 8, 2012, and Nov. 15, 2012, 4.9% of the 500 companies reported earnings. This 4.9% dropped the estimate for third-quarter earnings a disproportionate 44 cents. I expect the remaining 3.7% of the S&P 500 companies will drop the final number below the current estimate.

Using the Nov. 15, 2012, estimate for third-quarter earnings, the last four quarters put annual operating earnings at $97.75. As-reported earnings came in weaker at $87.35. Annual as-reported earnings have declined for both the second and third quarter. I expect the decline of the last two quarters is the beginning of a decline that will take real earnings down at least to the long-term trend and perhaps far below. After inflation, earnings have grown at about 1.9% a year over the last 70 years. This trend is shown by the green line in the chart below. Earnings are currently well above that trend. Reversion down to the trend would be normal.

The next chart shows the annual rate of change in real earnings compared to GDP. Real annual earnings are now just below where they were a year ago. The last 12 years have had the greatest earnings volatility in history. I expect this volatility to continue and for earnings to have a very large drop in the next one to four years.

Standard & Poor's estimated earnings suggest as-reported earnings will grow 13% in the next year. However, these estimates have a record of failing to warn of declines: There were also double-digit growth estimates as the last two earnings plunges began in 2000 and 2007.

The last two times annual real earnings turned negative in the chart above it roughly marked the beginning of major bear markets in the S&P 500 (SPY, IVV, DIA). I believe another bear market has started; however, I obviously cannot be totally sure. If the high was not in September, I expect it will come within a few weeks.

Disclosure: I am short SPY, IVV, DIA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Disclaimer: There is no guarantee analysis of historical data and trends enable accurate forecasts. The data presented is from sources believed to be reliable, but its accuracy cannot be guaranteed. Past performance does not indicate future results. This is not a recommendation to buy or sell specific securities. This is not an offer to manage money.