The initial estimate of a decrease in real GDP for the fourth quarter of 2012 by the Bureau of Economic Analysis briefly revitalized the debate over recession or continued recovery-very briefly. The rise in investor sentiment that has accompanied the upward move in equity indices through the magical numbers of 14,000 and 1,500 seemingly muted any would-be concerns. What has gone largely unnoticed is the recession in corporate profits that appears to be under way, which I think has more significant and timely implications from an investment strategy standpoint. In this instance, I am defining a recession as two consecutive quarters of declining operating earnings for S&P 500 companies.
In reviewing the weekly updates on Standard & Poor's website for S&P 500 index earnings, it is notable that operating earnings declined from $25.43 in the second quarter of last year to $24.00 in the third quarter. Still, such a decline has happened with enough frequency when examining the historical data, which dates back to 1988, that it is statistically irrelevant. What is relevant is that with slightly more than half of the companies having reported results through the end of January, operating earnings are on track to decline for a second consecutive quarter to $23.83. This is well short of the consensus estimate at the beginning of January.
Should operating earnings decline for a second quarter in a row, as I expect, it would be statistically significant because it has only occurred on three prior occasions dating back to 1988. Operating earnings declined in the third and fourth quarters of 1990, in the third and fourth quarters of 2000, and then in the third and fourth quarters of 2007. The earnings decline in 1990 coincided with an economic recession and preceded what was an eventual 19% decline in the S&P 500 index, while the earnings declines in 2000 and 2007 both preceded recessions and eventual bear market declines in the S&P 500 index.
Bullish analysts will say that "this time is different," because significant pension expenses for high-profile companies have reduced operating earnings. The widening gap between analyst estimates and the operating earnings that are being reported for the fourth quarter of 2012 is in part due to analysts not accurately accounting for the recognition of pension liabilities as charges against earnings. However, this is not a valid argument that earnings are somehow better than what is being reported. The Financial Accounting Standards Board (FASB) clearly outlines in rule 158 that expenses incurred to fund defined benefit plan obligations are not considered special items, and therefore must be included in operating income. Recent announcements indicate that such charges will continue to weigh on operating earnings in future quarters, as the allocation of corporate pension fund assets to fixed-income suffers from lower discount rates, due to the Federal Reserve's zero-interest-rate policy.
Regardless of the increase in pension expenses, revenue growth is slowing dramatically at a time when profit margins are at historical highs. It does not seem plausible that current margin levels can be maintained, considering the tax increases and spending cuts in progress, which are likely to result in a continued decline in operating earnings. The consensus estimate of $111.50 in S&P 500 operating earnings for 2013 is irrationally optimistic, but necessary in order for Wall Street strategists to substantiate a continuation of the bull market that will lead to new highs in the S&P 500 index.
Bullish strategists and investors will say that "this time is different," because the Federal Reserve will continue to drown the banking system in a tsunami of liquidity that will work its way into the stock market, defying the deteriorating fundamentals. I think the fact that each successive round of quantitative easing has led to diminishing returns for the stock market is proof that deteriorating fundamentals are starting to turn the tide.
The empirical evidence shows that there is a strong correlation between two consecutive quarters of declining operating earnings for the S&P 500 and both economic recession and declining equity values. This leads me to the conclusion that this time is not different, and that if we have not already realized the cyclical high in the S&P 500 index for this bull market cycle, we will do so shortly. This will be followed by a decline that realigns valuations with deteriorating fundamentals. As a result, reducing risk at this juncture is the prudent portfolio strategy move, as opposed to what individual investors appear to be doing based on recent fund flows.
Additional disclosure: DISCLOSURE: Lawrence Fuller is the Managing Director of Fuller Asset Management, a Registered Investment Adviser. This post is for informational purposes only. There are risks involved with investing including loss of principal. Lawrence Fuller makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by him or Fuller Asset Management. There is no guarantee that the goals of the strategies discussed by will be met. Information or opinions expressed may change without notice, and should not be considered recommendations to buy or sell any particular security.