As the stock market indices have muscled to new multi-year highs in each of the first six weeks of 2013, the consensus of individual investors has finally been convinced that now is the time to invest, based on the data provided by the Investment Company Institute that shows positive flows into equity mutual funds for the month of January. There are also significant sums flowing into the largest ETFs by assets representing the broad market indices such as SPY, QQQ and IWM. This reversal in trend for equity mutual fund flows follows 20 consecutive months of net outflows. The last positive inflow was in April 2011, when the S&P 500 finished the month at 1363.61, just prior to an 18% decline over the following four months.
Wall Street continues to report that fourth-quarter earnings releases are beating expectations, with some 68% of companies exceeding estimates. This makes for an alluring headline. Regardless of what expectations were, or what they are today, earnings are declining as stock prices are rising. That is all that is relevant. Last week, I wrote about the looming recession in corporate profits, and the historical precedent for a market decline coincident with two consecutive quarters of declining S&P 500 operating earnings. Following the latest weekly update on Standard & Poor's website for S&P 500 index earnings, the recession is no longer looming, it is a reality.
With 343 companies having reported, operating earnings fell another 30 cents for the fourth quarter to just $23.53. These results appear to solidify not only two consecutive quarters of declining earnings, but two consecutive declines in earnings year-over-year. If this figure holds for the remainder of the earnings season, operating earnings will be $97.20 for 2012, which is less than a 1% rate of growth above the $96.44 reported for 2011. If not for a declining share count, due to corporate stock buy-backs, earnings would have declined for the entire year. It comes as no surprise that at the beginning of 2012, the consensus estimate was for a 10% increase in operating earnings to approximately $107 - an estimate that was off by about 10%. This miscalculation has not deterred the eternally optimistic sell side. The S&P Capital IQ consensus estimate for 2013 is $111.36, which is a 14% increase above 2012. The growth is back-end loaded of course, but even the first-quarter estimate of $25.71 seems like a very big stretch.
Corporate revenues rose to a new high in the fourth quarter of 2012 after stagnating since the fourth quarter of 2011. The revenue increase was driven largely by the consumer staples, consumer discretionary and technology sectors as seen on the sales per share data available on Standard & Poor's website. There is a clearly visible seasonality to the strength in fourth-quarter revenue for these sectors every calendar year. Technology benefits from the year-end budget flush by corporations, and the consumer-related sectors benefit from the surge in spending during the holiday season. Another significant one-time factor for the revenue increase in the fourth quarter was the spending required to replace goods and provide services following Hurricane Sandy.
The reason for the decline in earnings, despite the surge in revenues, is that margins continue to erode. Operating margins peaked in the third quarter of 2011 at 9.51%, and they are on track to decline for the fourth quarter to a new cycle low of 8.24%. To be fair, we should see a significant increase in operating margins for the telecom and utilities sectors in the current quarter that may lead to an overall increase for the index, but the trend is clearly down. Additionally, there is a seasonal decline in revenues for the technology and consumer-related sectors in the first quarter of every calendar year, as well as overall S&P 500 revenues. This was evident in the first quarters of 2011 and 2012. How then can analysts forecast a surge in first-quarter earnings to a new high of $25.71? This is simply wishful thinking. We would have to see no decline in revenues in combination with a rebound in operating margins above 9% in order to achieve this estimate.
When accounting for $162 billion in tax increases that is sapping consumer spending power, and the inevitable spending cuts and additional tax increases that will result from sequestration, it is hard not to imagine earnings declining from current levels, much less increasing. I believe current estimates will be reduced significantly in the coming months, and that actual earnings may decline year-over-year depending on the details of the impact of sequestration. The current forward 12-month P/E ratio for the S&P 500 index is 13.6. The P/E ratio is based on Friday's closing price of 1517.93 and the forward 12-month EPS estimate of $111.36. This 13.6 P/E ratio is above the prior five-year average forward 12-month P/E ratio of 12.8. If we see no growth in operating earnings in 2013, and the index were to fall in line with the five-year average forward 12-month P/E ratio, the index would decline to approximately 1250.
If the upside targets in the S&P 500 index for 2013 are in any way a derivative of 2013 earnings estimates, then those targets will need to be revised as estimates are reduced. Otherwise, new reasoning will need to be provided for a further increase in valuations. I'm not sure what those reasons will be, but it is hard to argue that a company will be worth more in the future as the rates of growth in earnings and revenue decline and margins erode. From an investment strategy standpoint, there are measures that can be taken to hedge a decline in the broad market, and protect portfolio gains to date.
Most investors concentrate on sectors and individual companies that they expect to outperform the broad market on either an absolute or relative basis, exhibiting what is called relative strength. Otherwise there is no sense in assuming the additional risk associated with more concentrated investment exposure. Yet we can often be blinded to the macro-economic developments that impact the broad market by focusing solely on the bottoms-up merits of our individual holdings. Pairing long exposure with inverse ETFs like SH and RWM that will appreciate if the S&P 500 and Russell 2000 indices decline is one strategy that may mitigate losses during either a market correction or bear market decline. These are not ETFs that should be considered as long-term investments, but rather short- to intermediate-term tools that can mitigate risk.
Disclaimer: 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. Clients of Fuller Asset Management may hold positions in the ETFs mentioned in this article. 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.