Market / Earnings update: December 15, 2012: When Forward Earnings Estimates Don’t Work Well

There are a number of important earnings reports due out this week, including Oracle (ORCL), the enterprise software giant on Tuesday night; Fed-Ex, (FDX) the transport giant due out Wednesday morning; Bed, Bath & Beyond (BBBY) due out Wednesday night; Nike, (NKE) the athletic footwear giant due out Thursday night; and then Walgreens (WAG), the retail drugstore chain, is scheduled to release fiscal 1st quarter, 2013, earnings on Friday morning, December 21 before the open. (Disclosure: long ORCL, FDX, NKE).

We will get a reading on a wide swath of the US economy this week from these earnings reports, from FDX’s look across the globe from a basic industrial perspective, to Oracle’s read into enterprise tech and the cloud, and WAG, NKE and BBBY’s look into retail and the consumer.

There is little new to add to S&P 500 earnings: the forward 4-quarter estimate is now $109.09 as of Friday, December 14th (and per ThomsonReuters), 4.85% higher than the same estimate one year ago.

I feel like we are beating a dead horse here, but we continue to think that q3 ’12’s earnings for the key benchmark will be the nadir in terms of year-over-year growth and that q4 ’12 and forward quarters will show better growth than q3 ’12’s +0.1%.

The financial press continues to beat on the fact that 4th quarter, 2012 earnings are “only” expected to grow 4% year-over-year, downwardly revised from the 10% expected from q4 ’12 as of early October, but that is better than q3 ’12’s +0.1%, and the fact is forward quarters (as least in terms of how current estimates look) will continue to be better than the end of 2012.

The two big events of the last two months, the Presidential elections and the Fiscal Cliff (getting to hate that term) seems to have had an interesting effect on Corporate and Consumer America: the Cliff and the almost-certain higher cap gains taxes in 2013 has seemed to spur a rush of private client transactions and business on real estate and some business transactions to lock in the lower cap gains tax rate in 2012, while the pending Cliff has seemed to slow some aspects of Corporate America as enterprises and such seem to be on hold waiting for what tax reform might look like. (An old collegiate friend is a tax attorney in Cleveland with his own practice that revolves around manufacturing, and he is booked solid through q1 ’13 as a number of his clients are selling businesses now to lock in long-term gains. Heard something similar from another friend in Southern Wisconsin, around longer-term real-estate holdings.) Unfortunately that is very anecdotal, but it seems to be a growing theme.

It is currently a very strange macro environment, with very mixed data points on the economy.

The one aspect that doesn’t seem well understood in Washington is that tax reform changes consumer and investor behavior (without a doubt).

This coming week, we get more housing data (starts and permits and existing home sales) as well as the final look at 3rd quarter, GDP.  This coming Thursday’s Jobless claims release will no doubt get a lot of scrutiny. Last Thursday’s Jobless Claims release portends bullishly for the December employment report due out early in January, from what we’ve read.

When Forward Estimates Aren’t Predictive:  we’ve spent a lot of time educating readers on the importance of understanding forward earnings estimates and what that information tells us, but the fact is that sometimes – with the 2008 Great Decession (sic) as a prime example – forward earnings estimates can be flat out wrong.

We stayed bullish throughout 2008 because that “S&P 500 forward earnings estimate” was consistently rising up until early July, 2008, when it peaked at $104.07 on July 4th, 2008. (We’ve tracked this data weekly since 2000.) Even by late August, early September, 2008, that forward estimate had only been revised lower to roughly $100 per share, so the forward estimate didn’t capture the mortgage and liquidity crisis of 2008 until it was happening, and by then it was too late. We were in the teeth of a horrific market correction by September 15th, 2008, and the Lehman collapse.

The point is that forward earnings estimates may not be a great predictor of the “exogenous shock” and I’m not sure that the Lehman collapse and the mortgage crisis qualifies as “exogenous”, but the point is that in late 2008 the forward earnings estimates followed the crisis rather than helped predict the crisis.

And that brings us to a tangential and related topic this week: the nature of our recessions and business cycles has changed. When I studied finance and economics in the 1980’s and 1990’s (BSBA, MBA, CFA, etc.) the nature of the business cycle was cyclical, (and still is), with a foundation around manufacturing. Since the tech bubble burst and then housing popped (after a 60 year bull market in housing), much of the “traditional” economy such as manufacturing, actually continued to expand thanks to China and Europe (until the last two years anyway). The point being that I think 2000 and 2008 were the first “services” recessions we ever experienced, (and that is simply an educated guess and I could be wrong on that.) Services are now 80% of GDP, and have been since the mid 1980’s. The post WW II US economy was primarily manufacturing and agrarian based, which then transitioned in the 1960’s and 1970’s into a services based economy. The point is that the nature of our business cycle has changed in demonstrably the last 12 years, and continues to evolve as trading partners such as China and Europe suffer through their own issues.

Each recession and crisis is somewhat different than the last as the US economy continually evolves and changes its shape and structure.

To conclude, after the last 12 years and the two horrific bear markets we have experienced, the quality of today’s earnings and estimates are probably more “predictive” than historical earnings estimates, but the important element to remember is that we cant rely on any metric solely, and at the exclusion of others. The Cliff could present an issue with forward estimates if we have broad and far-reaching changes to our tax system. As of yet, in terms of revisions for 2013, that doesn’t seem to be in the cards.


Market/sector/security update:

  •  The 10-year Treasury has not made a new low in yield in almost 6 months or late July, 2012 when it touched 1.38%. Hard to say if a long top is forming in the Treasury complex. Ray Dalio, the famed hedge-fund manager and founder of Bridgewater & Associates, was interviewed this past week and said that the decline in bonds will be “the” trade (i.e. being short bonds) of the next century or something to that effect. The unusual element about Ray making such a statement is that he really isn’t prone to hyperbole. Ray thinks Treasuries start to rise in yield in late 2013. We remain long the TBF and will be long the TBT at some point. You can be patient with the TBF (unlevered or 1:1 inverse Treasury ETF) and you can time your Treasury short with the TBT (levered or 2:1 inverse Treasury ETF). (We use both but are only long the TBF currently.)


  •  It seems very strange to hear those “guru’s” and prognosticators be bearish Treasuries and interest rates (e.g. implying higher interest rates down the road) and then be bearish equity markets, like the US equity market or the S&P 500. Inflation would be beneficial to corporate earnings. It looks like the S&P 500 will finish 2012 with a 4% – 5% year-over-year growth rate for earnings, versus a – what – 1.5% core inflation rate (if that). The point being that “real” or inflation adjusted earnings continue to be positive. After 10 – 12 years of disinflation or deflation, a little faster rate of inflation might be welcome by the Fed. Certainly I think that a little inflation would be beneficial to corporate earnings.


  •  Day after day we continue to hear about recession worries in early 2013, mostly Cliff-related. The big surprise could be unexpected economic strength once Washington comes to some agreement and now that the Presidential election is behind us. Without a doubt, it seems there is a lot of short-side money riding on a recession in 2013, but the unexpected and lower-probability occurrence for 2013 would be economic acceleration. (The contrarian in us tells us that the “recessionista’s” can not all be right, and hopefully Washington is not that stupid).


  • Natural gas – there is a US manufacturing “renaissance” occurring in the US after two decades of losing jobs to China and Latin America, and ISI Group thinks it is due to lower natural gas prices and the US finding cheaper sources of energy by drilling domestically than by importing. The equilibrium price for natural gas is thought to be between $5 – $6 per MCF. While natural gas looks substantially undervalued at its current price, they keep finding more of it too. We are long only Encana (ECA) and are underweight Energy as a sector. We’ve never been very good energy traders as it was – still, I think the growing numbers of hybrid’s and eventually electric cars impacts gasoline prices and gas prices (supply and demand) are a huge determinant of crude oil prices. The price of electric cars seems to be the prime deterrent to widespread consumer acceptance at this point, but in effect the auto OEM’s are cannibalizing their own product lines. Eventually I expect prices to decline over time and for electric cars to gain greater acceptance. (I don’t qualify as an expert on this topic by any means, but electric cars and hybrids remind of PC’s in 1979 – 1980, i.e. consumers have a growing awareness of the technology, but pricing is still prohibitive, and it is still viewed as cutting edge rather than mainstream technology.)


  • Gold and silver – neither has an “intrinsic value” so it is impossible to tell whether the metals are cheap or not. We are long just a smidge of gold and no silver. After a 12 – 13 year bull market in both, there are far more gold and silver bulls in the market, which is what you’d expect. My own opinion is that the “long gold and short dollar” dollar trade of the last 10 – 12 years is nearing an end. Both have run their course. That doesn’t mean gold is a short or the dollar is a long trade, but that it will be more difficult to make money on that traditional theme. Goldman Sachs made a call the past few weeks saying the gold bull market has ended. (long a very small position on GLD in a few client accounts, and long GS).


  • Tom Lee of JP Morgan Asset Management was out this week saying “Basic Materials” will be the best performing sector of 2013. The forward earnings estimates for the sector for 2013 have been flashing positive signs, as we wrote about a few weeks ago. Currently Basic Mat – which is 3% of the S&P 500 by market cap –  is expected to have the highest level of earnings growth in 2013, at +22.2% up from 19% as of July 1. (Tom is looking at the same data we do.) Telecom is the 2nd highest sector at 20.8%, up from 17.5% as of July 1. The one quirk to these sectors is that – in total – basic materials and telco – are just 5% of the market cap of the S&P 500, or relatively tiny sectors. Technology is the largest sector at 20% of the key benchmark. If you are looking at Basic Materials, that would be Freeport (FCX), Alcoa (AA) and the steel stocks for starters. (Long Alcoa, sold in taxable accounts for the tax loss, kept in tax-deferred accounts.)


  • There will be a plethora of 2013 predictions about 2013 in the next few weeks, with very few firms telling you how their predictions panned out for 2012. Those whose forecasts and predictions were right for 2012 will crow about it loudly. One thing most individual investors do not consider is that no one person, or one firm, or one style or investing methodoology or economic or forecasting model is ever (and I mean, ever) CONSISTENTLY right about predicting the economy or the stock / bond markets. One lesson I’ve also learned in fact, is that the “righter” you are, the more wrong you will likely be, since success in the money management business often attracts assets, and the more successful you become with a particular strategy, the less likely you are to want to deviate from that strategy even though that is often the prudent course of action. This is a topic for a longer article, but as an advisor to individual wealthy investors, we try to stay flexible and think as much about risk as we do about return. With the 20 year bull market in the late 1990’s we didn’t do that, and like a lot of other shops, we should have. Don’t forget to sell on occasion, and don’t ignore valuation.


  •  Resurgent Chinese economy – the FXI (the China 25 Index ETF) had a big day Thursday as the Shanghai Composite rose 4%, its best day since 2009. We have played China through the FXI in the past. Haven’t owned that ETF in a long time.


  • The US market was outperforming most non US markets until the last month. I think some of that is AAPL’s decline, which is still a big part of the S&P 500 index. European markets are now up more than the S&P 500 for 2012 year-to-date.


  •  Facebook (FB) was one of our better calls this year. We bought most of it under $20.


  • Finally our corporate “high-yield” overweight in balanced or bond accounts remains, although Moody’s raised another red flag about the covenants starting to erode on new issues. This is what happens when you get a strong demand for a “yield”. You want to focus on corporate high yield when it is a buyer rather than a seller’s market, and today is an issuer’s market. Could be an early warning sign for the fixed-income market, but we remain overweight. About a month ago we sold one high yield fund and put the proceeds into the “Unconstrained” asset class which gives managers flexibility to move between and amongst asset classes, so we while we reduced our high yield overweight slightly, the proceeds are still predominantly in corporate bonds.


  • Municipal bonds – The MUB (National muni bond ETF) had a tough week and is sitting at key support. Could municipal bonds tax-exempt income be under the gun in Washington ? Be careful of your muni portfolios. Individual bonds would be safer on a risk/reward basis than either mutual funds or ETF’s if muni’s tax exemption gets thrown under the bus. We sold all of our muni’s in late November when we worried about this happening. We are still not “right” yet, but why take the chance, and we lock in capital gains at the 15% rate. This doesn’t smell good…


  • Wal-Mart at $65 – $66 is a screaming buy. Buy it all the way down. One of the best -run and under-loved companies in America. (long WMT, want to get longer.)



Thanks for stopping by, and as always, thanks for reading. We’ll be out during the Christmas break with some topical articles during the week. Questions, comments and criticism’s always welcome.

Trinity Asset Management, Inc. by:

Brian Gilmartin, CFA

Portfolio manager












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