Earnings Ghost Stories

With Halloween nigh, financial headlines are full of spooks. For any investor inclined to sift through it all, it risks being a full-time job. How can you know which are ghost stories, not actionable events? Here is one helpful trick when you read that Scary Thing X is happening in markets: Ask, “so what?”

Let us show you how this works using a scary story making the rounds: the S&P 500’s lopsided earnings growth.

About one-fourth of the way through Q3 earnings season, headline results look smashing. S&P 500 earnings are tracking up 29.5% y/y, with sales up 12.6%.^[i] But number-crunching analysts warn it is a mirage. The Wall Street Journal’s slicing and dicing concluded just 10 companies generated two-thirds of this growth.^[ii] Predictably, most of those 10 are AI-related giants. The Journal notes the 10% y/y collective growth of the other 490 constituents isn’t too shabby, but Bloomberg went a skosh further. They pulled out Tech, Energy, Materials and Defense to assess earnings outside AI and the war in Iran. Consider that core earnings growth, the real broad US economy, they say. And earnings there are tracking at just 4.5% y/y, per their math, scarcely outpacing inflation.^[iii]

So what?

We see two implications to pick apart. One, that single-digit earnings growth, excluding huge swaths of the economy, is dismal. Two, that earnings must beat inflation by a healthy margin.

Start with the first one. Is 4.5% y/y earnings growth really bad? Compared to nearly 30% headline growth it looks wimpy. But that isn’t the right comparison. Better: Look at earnings growth in prior bull markets. Specifically, look a few years in. Earnings usually soar early in an expansion, when sales bounce quickly from the recent recession and costs are low. That peters out after a couple years, when the year-over-year comparisons are tougher and sales growth more important. Today, we are six years on from the COVID lockdown-induced recession and four years from 2022’s recessionless bear market. So earnings from 2012, 2013 and thereabouts seem like logical comparisons.

Turns out, they weren’t stellar. Earnings dipped mildly in late 2012, then grew slower than 5.0% in 2013’s first three quarters.^[iv] Low single-digit growth and modest declines were the norm in 2014, 2015 and 2016 as Energy and manufacturing struggled.^[v] Headlines considered both bellwethers at the time, not outliers, and warned stocks were complacent. But the bull market romped on. The S&P 500 rose nicely in 2014 and 2016 (a correction’s timing kept returns flattish in 2015), and the bull market continued until COVID lockdowns truncated it in February 2020.^[vi] Seems to us a supposedly weak earnings growth rate was just fine.

As for earnings slowing toward the inflation rate, again, so what? Think this through. Yes, inflation lifts businesses’ revenues. It also lifts their costs. It affects both sides, which kind of cancels it out. When you subtract nominal costs from nominal sales, you basically subtract out the inflation. If you are into profit margins, you go one step further and divide net income by sales. In this calculation, inflation makes the denominator bigger, rendering smaller margins. Sorry, but we fail to see how any further inflation adjustment would be necessary. The margins would already account for elevated costs. Comparing earnings’ growth rate to the inflation rate seems like mere, pointless trivia.

So earnings outside AI and the Iran war are growing at rates stocks were fine with a decade ago. Slow growth then wasn’t a loss of momentum. It wasn’t a prelude to recession. Contrary to headlines at the time, earnings weren’t a rocket failing to achieve escape velocity and soon to crash. It was all normal. What was normal and bullish then can be normal and bullish now, especially when headlines call the US economy a two-trick pony and increasingly question even those two tricks.