A little further down is a chart I made that I think may be helpful in explaining the current market to new investors.
This chart shows the trailing four-quarter sales and earnings for the S&P 500. This needs a little explanation. The black line is the sales for the S&P 500 and it follows the right axis. The blue line represents the operating earnings and the red is the as-reported earnings. Both of those lines follow the left axis. Notice that sales are much less volatile than profits.
I’ve scaled the two axes at a ratio of 12-to-1, which means whenever the red or blue line crosses the black line, the profit margin is exactly 8.33%. Unfortunately, the data only goes up to the first quarter of this year, but nonetheless, I still think it gets the point across.
Let me explain the difference between the red and blue lines. The as-reported figure refers to simply the bottom line that companies report each quarter. The blue line is the earnings number that’s adjusted for special items. Personally, I prefer to look at operating earnings because the market has historically been more closely correlated to it. Some analysts only look at as-reported earnings and I respect that choice. You can use either but just be aware of the pitfalls of either choice.
The problem with as-reported earnings is that they can fall off a cliff as they did during the fourth quarter of 2008. AIG, for example, reported an earnings loss of over $280 a share. When all those financial stocks reported monster losses it gave the impression that the entire market was worthless. The red line plunged to nearly nothing. The market, obviously, didn’t put a standard multiple on $7 of trailing earnings. Instead, the market’s behavior followed the blue line. I’ll skip the accounting debates. My view is that if market thinks the blue line is important, then I think it’s important.
The problem with the operating earnings, however, is that it can reflect poor “earnings quality,” meaning companies get creative with their accounting. A good warning sign of poor earnings quality is when there’s a big gap between the red and blue lines. This was a bigger issue a few years ago, but I’m not so concerned about it today.
Either way, let’s not get bogged down on the issue of operating versus as-reported. The important point I want to get across to new investors is that the market has responded to a dramatic upsurge in operating earnings since March 2009. That’s great news. The problem is that companies haven’t grown their profits by generating new business. Instead, they’ve grown their profits by increasing profits margins. And they’ve done that by cutting costs, principally labor costs. They’ve fired and laid off their way to prosperity!
Basic economics tells us that profits can only go so far without sales growth and that’s been dismal, and it’s partly due to all those lay offs. That black line needs to get moving. The Q2 data point isn’t up yet but it will show pretty much the same thing, sluggish sales growth.
I scaled the two lines at 12-to-1 because once the blue line passes the black line (meaning, the overall profit margin exceeds 8.33%), that’s usually when the economy starts hitting the breaking point. When you can’t increase sales quickly, you need to grow earnings by raising prices. But when you increase margins, you slow sales growth. Hence, the economy moves in a cycle. Notice how the blue line tends to lead the black line by a year or two.
In other words, profits generate sales. But this time around, it just doesn’t seem to be working.
Ed Elfenbein is editor of Crossing Wall Street, a Web site about stocks and the market designed to help individual investors. Check out his free Buy List of stock recommendations.
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