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Philly Fed Points To Weaker Profits Ahead

  • Written by Syndicated Publisher 284 Comments284 Comments Comments
    April 20, 2012

    philly-fed-netprices-041912The media has been busy today flashing up charts showing the percentage of companies that have beat earnings estimates so far this quarter.  While still very early in the earnings season currently – roughly 81% have managed to best expectations.  This sounds pretty incredible until you realize two things.  First, earnings estimates were drastically lowered from a 10% expected growth rate in October to less than 1% just before earnings announcements started.  Without this massive decline in estimates the number of companies not beating estimates would be near 100%.

    Secondly, the majority of companies are only able to beat estimates using accounting gimmickry such as Bank of American and Morgan Stanley.   Bank of America took a $3.3 billion adjustment to Fair Value Obligations without disclosure, which smells very fishy, and a $1.5 Billion DVA adjustment.  All in all .28 cents were added to the bottom line to lead to a total .31 cent EPS number.  When accounting for real revenue – well there actually wasn’t much despite all of the arm waving.  Morgan Stanley today was not much better as there earnings included $2 Billion of DVA which would have wiped out all of their gains.  The point here is that if we go back to reporting earnings based on GAAP accounting, as used to the be the requirement, the current run of earnings would be far less exciting.

    However, what does that have to do with the Philadelphia Fed Manufacturing release this morning?  It is all about pricing pressures.  The sharp decline in the index, which is due to the fading of the warm winter weather effect as discussed yesterday, showed the majority underlying subcomponents weakening.  One area that we watch particularly closely is net prices.   This is simply the difference between the prices paid and the prices received.   As shown in the chart, this indicator has only eclipsed 30 on the index a few times in the past.   Each previous peak in the net prices index was a precursor to a subsequent decline in corporate earnings as profit margins were squeezed by higher input costs and lower ability to pass them through to the end consumer.

    Without all of the “accounting magic” that riddles companies income statements these days – it is very likely that we would not have seen such a sharp ramp up in earnings post the 2008 recession considering the real weakness of the underlying economy, high unemployment, etc.   The repeal of mark-to-market accounting for banks, revenue accounting schemes to apply revenue that hasn’t been received and a variety of other quirky measures have led to the massive resurgence of earnings.  The problem, however, is that they are not quality earnings in many cases and will do little to support companies prospects during the next economic recession.

    The decline in the net-prices index is something that we need to be watching closely.  While companies are currently crawling across near zero earnings growth estimates – the reality is that any economic weakness at all will quickly push those earnings negative in the coming quarters ahead.  This will in turn lower valuation assumptions for stocks bringing prices down.  We are very long into the current cycle and while analysts continue to expect higher levels in future quarters and years ahead historical cycles tell us a far different story.

    Images: Flickr (licence attribution)

    About The Author

    Lance Roberts – Host of Streettalk Live

    lance robertsAfter having been in the investing world for more than 25 years from private banking and investment management to private and venture capital; Lance has pretty much “been there and done that” at one point or another. His common sense approach has appealed to audiences for over a decade and continues to grow each and every week.

    Lance is also the Chief Editor of the X-Report, a weekly subscriber based-newsletter that is distributed nationwide. The newsletter covers economic, political and market topics as they relate to the management portfolios. A daily financial blog, audio and video’s also keep members informed of the day’s events and how it impacts your money.

    Lance’s investment strategies and knowledge have been featured on Fox 26, CNBC, Fox Business News and Fox News. He has been quoted by a litany of publications from the Wall Street Journal, Reuters, The Washington Post all the way to TheStreet.com as well as on several of the nation’s biggest financial blogs such as the Pragmatic Capitalist, Zero Hedge and Seeking Alpha.