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Has the market priced in an 'earnings recession'?

When we all have worried for long enough and prices go down, markets get less risky, not more.

Greece and China didn’t get “fixed.” Investors just fretted over them enough, and market prices adjusted sufficiently, to make them seem less an immediate threat to economic health. And then the value of stocks and bonds not in the direct path of the damage lofted.

The corporate debt market was ruffled and cheapened by the oil crash and too much risky new issuance. But without a nasty accident touching the banks or the flow of capital to sound companies, credit measures have stabilized for now, allowing stocks to bounce - for now. 

So have we endured enough angst over the pronounced retreat in corporate profits, and appropriately knocked down the shares of the backsliding companies in the late-summer market tumble?

Earnings for the S&P 500 (^GSPC) companies are set to have dropped nearly 5% in the third quarter, based on the 60 or so companies that have reported and forecasts for the rest.

The current level of expected profits over the next year is virtually the same as it was in July of 2014 – and - What do you know? - the index is also roughly at the same level as back then.

We’re now hearing more talk of an “earnings recession,” with plenty of confusion and disagreement over what it means.

Deutsche Bank economist Torsten Slok says most of the profit carnage is related to energy and emerging-markets exposure, with a stiff headwind from a stronger dollar that should start to wane in coming quarters. He’s convinced this is an earnings recession without much risk of a broad economic recession. This is also pretty much the consensus view. 

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Profit margins more broadly have held up, though there is an increasing gap between “operating” profit measures and strict “reported” earnings, which include restructuring charges and whatever else companies choose to set aside. According to Yardeni Research, the four-quarter average operating profit margin has risen to 10.5% or so, while the reported margin has ebbed to just over 8% - the widest gap of this cycle.

There is, for sure, an increasing number of big, widely watched companies that have come to the end of the earnings-management string and have had to concede their underlying earning power is diminished. This includes Wal-Mart Inc. (WMT) last week and International Business Machines (IBM) last night.

Wal-Mart radically reduced its forward profit path, suggesting it had been “over-earning” through underinvestment and financial maneuvers. IBM capitulated and abandoned its long-held $20 per share earnings target for 2015, which the market had effectively written off a while ago. Both stocks went dramatically lower, and arguably are more cheaply valued.

The hope and belief out there is that Wal-MArt is dealing with a Wal-Mart issue and not a pervasive consumer slowdown. IBM is considered a lost, lumbering giant not representative of technology in general. But can investment bank and broker Morgan Stanley's (MS) continued profit struggles and weak returns be considered compasny-specific, when the SPDR Capital Markets Sector ETF (KCE) is down to levels first reached more than two years ago?

 

Across the market, the divide between the haves and have-nots has widened, for sure. Even in the beloved consumer discretionary sector, a handful of big winners such as Amazon (AMZN) and Nike (NKE) are hogging the glory, while the equal-weighted version of the sector is down year to date.

The bull case from here is that localized pressure on profits has made its way into many sectors, but hasn’t turned the profit trend lower for good. Barclays Capital is out with a report saying the familiar, if tired, stock buyback and merger machine still has the fuel of cheap debt and willing buyers. The breakup of Yum Brands (YUM) suggests the activist-driven financial engineering story isn’t quite done yet.

These trends are all far along and are showing reduced efficacy. And the market’s certainly not outright cheap at 17-times the coming year’s projected profits, as the S&P runs up against levels that have thwarted it in the past.

Maybe if we all worry real hard about all this a while longer, the market can make its peace with such concerns and move on.

 

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