Grant's Almost Daily.

Will Corporate Earnings and Stock Prices Revert to the Mean?

Is this as good as it gets? Mr. Market has been a little cranky of late, sending stocks down despite phenomenal results.  With 154 components of the S&P 500 having reported as of this morning, the average sales (1.97% above consensus) and earnings surprises (7.25% above consensus) are easily the best relative performance in each metric in at least the last eight quarters, according to data from Bloomberg.  On an absolute basis, the S&P 500 components have so far managed 10% year-over-year sales growth, far above the top-line growth logged in at least the prior four quarters. Yet since the commencement of earnings season on Feb. 16, the S&P 500 has dropped by 3.4%, a 17% annualized pace.

Yesterday, a number of economic bellwethers offered seemingly solid quarterly results that were met rudely: Shares in truck manufacturer Paccar, Inc. (PCAR on the Nasdaq) dropped by 7% despite topping consensus expectations for the first quarter and offering an upbeat forecast for Class 8 truck sales.  Ronald E. Armstrong, chief executive officer, expressed optimism on margins, telling listeners to the earnings conference call that: “We feel good about the operating results. We have the best margins – the best operating margins in the industry.”

Industrial conglomerate 3M Co. (MMM on the NYSE) topped sales forecasts and met the Street’s expected adjusted earnings per share figure, yet shares declined by 7% after the company trimmed the upper end of its fiscal year earnings forecast. Analysts at RBC Capital Markets observed that: “While this guidance cut is relatively small, the implications are magnified, given that it is happening so early in the year.”

Masco Corporation (MAS on the NYSE), a maker of building and home improvement products, saw its shares fall by 9% despite stronger than expected revenues, as higher than expected investment spending and the “price cost relationship in plumbing and cabinetry” dinged the bottom line. Perhaps most instructively, machine and mining equipment giant Caterpillar, Inc. (CAT on the NYSE) reversed strong initial gains following impressive results, after the company CFO Brad Halverson noted on the company conference call that the first quarter “will be the high watermark for the year.”

Meanwhile, a dispatch from Bloomberg this morning details the struggle in the U.S. grocery store industry to raise prices, despite the seemingly perfect macro-economic backdrop for such hikes: Low unemployment, sturdy consumer confidence and an uptick in measured inflation. Instead, an intense competitive environment featuring foreign interlopers Aldi and Lidl, the specter of cross-industry boogeyman Jeff Bezos, as well as diminished brand loyalty on the part of consumers, have put the squeeze to the consumer packaged goods industry (a development which informed the bearish calls on packaged food companies such as Kraft-Heinz Company and Campbell Soup Company in the March 24, 2016 edition of Grant’s). Bloomberg says:

“There’s no question the balance of power has shifted,” said Gary Stibel, who runs the New England Consulting Group, which advises consumer companies. Packaged-food and consumer-product companies aren’t “creating the kind of intense” loyalties that retailers need to be able to pass on higher prices to shoppers, he said.

Overall, corporate profits have remained well above 10% of U.S. gross domestic product in every quarter since the third quarter of 2009, peaking in the fourth quarter of 2014 at 12.6% according to data compiled by the Bureau of Economic Analysis as of Dec. 31, 2017. That compares to a post-1948 average at 9.6% of GDP. In a 2014 essay in Barron’s, co-founder of Boston’s GMO Jeremy Grantham called corporate profit margins “probably the most mean-reverting series in finance.”  Grantham subsequently shifted his perspective, writing in a May 2, 2017 Barron’s follow-up that: “I used to call profit margins the most dependably mean-reverting series in finance. And they were through 1997.” Increased globalization, consolidated corporate power, and lower real interest rates were among the factors that influenced the great investor to change his mind.

What if Grantham’s 2014 viewpoint turns out to be the correct one? Needless to say, equity bulls will get no help from valuations.  The current Shiller Price/Earnings ratio (based on average inflation-adjusted earnings over the last 10 years) on the S&P 500 stands above 31 times, nearly double the long-term median and mean readings of 16.15 and 16.85 times, respectively.

Philip Grant