Earnings Estimates

All posts tagged Earnings Estimates

Two articles published overnight indicate that the period of central bank omnipotence has ended. The Daily Telegraph carries this commentary on the ECB exhausting its ability to improve the Eurozone economy and this piece about the need for central banks to continue to project omnipotence, whatever the reality. One of our favourite analysts, Ben Hunt, has already declared  that central banking influence is on the wane.

Our recent blog on the logic of investors doubling up equity positions through the option market concluded that this strategy was rational when central banks are the primary influence over stock markets. It stands to reason that if this influence is on the wane, then the risks to equity exposure are mounting.

At OTAS we spend a lot of time looking at the indicators that may inform investors about a change in trend. One popular indicator is the level of credit default swaps, shown here for the median US large cap.

US Large Cap Median CDS

US Large Cap Median CDS

The lowest level of risk for US companies on this measure was June 2014. We have noted that this corresponded to the approximate peak in global export volumes and that economic momentum has deteriorated subsequently. The Fed indicated its taper strategy in December 2013 and officially ended bond buying in October 2014, but it was not until April 2015 that the cost of credit for US corporates began a meaningful rise. Credit risk has returned to its average level and stalled. This may indicate a reluctance to believe that the Fed can raise interest rates meaningfully.

US Large Cap Median Implied Volatility

US Large Cap Median Implied Volatility

Implied volatility is another favoured measure of risk. This also reached a trough in the summer of 2014 and showed a more meaningful pick up from Q2 2015. The reduction in implied volatility since February however, is at odds with the CDS risk indicator. This may suggest that the actions of investors are supressing volatility without the same degree of support from central banks as in the past. This is either because corporate earnings are on a growth trajectory, or because a bubble is forming based on past behaviour by central banks.

US Large Cap Median PE

US Large Cap Median PE

The PE valuation of US large caps is above its average range and on the verge of completing four weeks of decline from close to record highs this cycle. PE can fall due to rising earnings or falling prices and there is nothing to stop the two occurring simultaneously.

The situation in Europe sees the PE valuation of large caps at the very top of the average range. Relative to US stocks the valuation is mid-range, as shown below. The relative valuation has been rising since early July, which may be currency related. It does not, however, bear out relative rates of growth and is not factoring in that further ECB action may be detrimental to the economy, as suggested in the first article referred to above.

European Large Cap Median PE relative to US Large Cap

European Large Cap Median PE relative to US Large Cap

Our final chart shows the valuation of large cap UK stocks. This looks a lot like the US chart, albeit at slightly lower levels of PE. Short term positive EPS revisions are dominated by the Materials sector; much as Energy stocks dominate the list of most recently upgraded US shares. In Europe, ex the UK, without such a prominent resources sector, upgrades show no obvious sector bias.

UK Large Cap Median PE

UK Large Cap Median PE

The last month suggests that cracks are beginning to form in the equity bull market thesis. One rationale for this is that the power of central banks to influence stock prices is diminishing, perhaps at an accelerating rate. The bigger point is that monetary policy alone has been insufficient to drive an economic recovery that translates into corporate earnings rising as quickly as stock prices. One has to doubt that investors will afford politicians and fiscal policy the same perceived omnipotence as they have allowed central banks and monetary policy in recent years.

One of the funny things about the stock market is that every time one person buys, another sells, and both think they are astute – William Feather

The media is alive with lurid stories of volatility back at seven year highs. This refers to foreign exchange volatility and it is hardly surprising, as central banks have done their level best to dampen volatility for seven years, but everyone knew that this would last only as long as market participants chose to believe. If Brexit is indeed the reason why currency markets are aquiver, then this should be no surprise as the campaign for the UK to leave the EU has risen in defiance of central bank warnings, along with those of the rest of the establishment.

Back in April we published a post arguing that there was no evidence of Brexit related volatility in equity markets. OTAS implied volatility (risk) analysis centres on three-month single stock options and so April was already discounting expectations for the post referendum period. The prevailing consensus, however, may well have been that there was no way that the UK would vote to leave, and it is this consensus that is being shaken with reports of nine out of ten recent bets placed with bookmakers anticipating Brexit.

UK Shares Average Implied Volatility - Short Term

UK volatility, whereby options investors expect a +/- 16% move in share prices in three months, is at the top end of its two year range. This is +/- 1.5% more uncertainty than in April. Today’s level, however, remains below the peak in February, when it is worth remembering that the prevailing panic was about global growth, not politics. Last night US bond spreads were at nine year lows, which is a recession warning, and it would be a stretch to blame Brexit for concerns over domestic US economic growth.

UK Shares Average Implied Volaility - Long Term

It is also worth viewing UK equity volatility in a longer historical context. Compared with previous peaks in 2011 and 2008, the recent increase in uncertainty barely registers and remains well within normal bounds. Even during February’s market fall, when the prevailing wisdom was that there would be a recession this year and not one triggered by UK voters, uncertainty did not rise beyond the normal range. Investors should keep an eye on this measure over the next eight days to judge how far the Brexit hysteria spreads.

UK Company Aveage P/E - Short Term

UK average P/E valuation has fallen back into the normal two-year range, having reached a peak in mid-April. The valuation has moved, swung would be too aggressive a description, between 14x and 17x over the last two years and could fall another 8% before reaching that lower valuation. The drop since mid-April has been 10%.

A look at earnings also suggests that there is little to be overly concerned about in the world of equities. Analysts have been downgrading UK shares more often than upgrading for the last six months, but the ratio of downgrades to upgrades has fallen recently.

 Average UK Share

Upgrades over 1%

Downgrades more than 1%

Last 6 months

33%

59%

Last 3 months

30%

39%

Last 1 month

13%

18%

Source: OTAS

While it would be convenient to blame economic uncertainty caused by potential Brexit for the downgrades to earnings expectations, if this were the main reason for changes, then the downgrades would surely intensify as a leave vote became more probable. The opposite is true. We do well to remember that analysts almost always start a year more positively than they finish it, as reality bites into bonus-period optimism. Analysts are also notorious for not changing their estimates until guided to do so, thus there is a reasonable chance that company executives would use the cover of a leave vote to downgrade their outlook, whatever the underlying reason for caution.

With even Mark Carney admitting that the Chinese debt mountain is a greater concern than Brexit, there are plenty of excuses for corporate chieftains to cut themselves a little slack. Keep an eye on the OTAS measure of implied volatility for an early steer as to when this becomes a cliff edge issue, rather than the gentle undulation that it is at present.

The results are in for the first quarter earnings season in the US and do not make for pretty reading. For the sixth consecutive season, operating earnings of the largest companies have declined. A little over one fifth of companies issued earnings guidance and, of those, 71% advised analysts to lower their expectations. The gradual erosion of the earnings base of the country’s largest companies has taken its toll on the valuation of the stock market.

US May 16

The valuation of the market peaked in May 2015, just over a year ago. There was a first quarter rally on the back of more monetary easing in Europe, but the impact on US companies is likely to be short lived. When the ECB announced that it would be buying European corporate debt, this boosted the value of debt and pushed down the yield that borrowers have to pay. Large US companies can take advantage of this to raise debt in Europe and use the proceeds to buy back shares to temporarily support stock prices.

The decline in earnings also has a short term impact on valuation, by raising the market multiple, but as the chart shows, the more powerful force is the growing momentum out of US equities in response to declining profitability.

There is some good news, however. OTAS makes it easy to filter a market or portfolio of stocks to find those where the trend in earnings is bucking the general malaise. There are 33 companies with falling share prices and rising EPS estimates, where this contrast is sufficiently significant to stand out from the rest of the market. Ten of these shares are in the energy and materials sectors, which are whipsawed by the anticipated moves in currency and commodity markets, but the remaining 23 shares are trading at a 22% discount to the average valuation of the broader market.

The US stocks bucking the earnings malaise

By applying one filter for stocks with significant divergence between falling price and rising EPS estimates, and a second excluding energy and materials shares, in just a handful of clicks we are left with a chart showing only the outliers across the whole market. Hovering over each yellow disc reveals the name and recent performance of the company. Frontier Communications is highlighted below.

Another look at the stocks bucking the negative trendDouble clicking the name takes you to the EPS Momentum page for Frontier Communications and to a chart that shows the relationship between the share price and estimates of upcoming earnings. In the case of Frontier, investors were faster than analysts to realise the downgrades that plagued the last nine months of 2015, but both analysts and investors have been in step since the beginning of this year. Then the share price weakness over the past month contrasts sharply with the average 8% upgrade to forward earnings posted by the analyst community.

Frontier Communications' Loss Estimates Fall

Obviously it is up to investors to decide whether the recent share price weakness heralds another false dawn for the company, but OTAS provides layers of analysis to help make this judgement. For example, Frontier’s estimates have risen for the years to December 2016 and 2018, but fallen for 2017, so it may be that investors are most focused on next year. Frontier’s borrowing costs over seven times that of its industry peers and the shares may thus have reacted to the renewed prospects for a summer rate hike. Frontier will also pay a dividend in 20 days times and has a forward yield of 8.6%, but while free cash flow covers the pay-out, earnings do not.

All of these factors influence the decision to buy or sell Frontier, or indeed any stock. OTAS provides a one-stop shop for all the market intelligence that you need to make sure that you are as fully informed in your trading or investment decision as you can be. OTAS also draws out the priority issues that are impacting share prices, to help fundamental investors frame the most pertinent and timely questions when they interrogate a company’s performance, its financials and its management.