Like Icarus, earnings estimates are flying too high

Despite signs of slowing, analysts seem to assume earnings can go up forever.

By Feb 20, 2013 2:38PM

Skyscrapers copyright Ted Wilcox, CorbisIn Greek mythology, Icarus failed in his attempt to escape the island of Crete because he succumbed to hubris and didn't heed his father's advice.

Icarus' father repeatedly warned that the wings he had built were made of only wax and feathers and would melt if the youth attempted to fly too close to the sun with them.

The story ends with Icarus falling to his death. He got caught up in the euphoria of flying and made the mistake of becoming overly ambitious in his escape.

Perhaps we too should take a step back from our giddiness when it comes to 2013 earnings that may also still be flying too high.

Bottoms up earnings

Earnings season for 4Q 2012 is in full swing with 78% of constituents reporting and a few of the larger retail ones still remaining.  

On Feb. 27 Target (TGT) reports and on Feb. 21 are Hewlett Packard (HPQ) and Wal-Mart (WMT). March wraps up with some more large retailers like Costco (COST) and Staples (SPLS).

The top down earnings

S&P 500's (SPY) reported earnings for 2012 are expected to reach a new all-time high at $88/share. For comparison, 2011's reported earnings were $87/share and 2Q 2007 trailing (the previous stock market peak) was $85/share. 

By the end of 2013, analysts are expecting earnings to grow 15% to another all-time high of a reported $101/share.  Below are the latest S&P earnings for the past year and next year's reported estimates in columns 1 and 2, annual growth rates in column 3, and a comparison of today's estimates with the ones that were estimated back in October in columns 4 to 6 (when I wrote another article on the lofty earnings found here). Since then earnings estimates have come down, but is it enough?

It seems analysts and companies are all expecting continued earnings growth into next year as the above S&P data supports. But very few seem to be concerned that earnings growth continues to be ratcheted down and pushed out as the latest headline from Forbes identifies, but doesn't comment on" "S&P 500 Revenue and EPS Estimates Ratchet Down After January Results." 

After the dust has settled, full-year 2012 earnings barely grew at all (estimated now to be only 1.2% over 2011), but 2013 full-year earnings are still expected to grow even more than 2011's impressive 12.4%. Even more, margins are now starting to fall for the first time since 2009 (more on that below).

All four of the latest earnings quarters have been clawed back, some significantly, yet 4Q 2013 remains unscathed and elevated as companies are unwilling (so far) to come off of full-year guidance, adding up to a 15% year-over-year growth. 

On Oct. 9, 2012 with the S&P at 1,450 we first identified earnings estimates as being too lofty. 

Those estimates indeed have fallen and we were able to take advantage of the market's technical decline into November in our Technical Forecast published Oct. 10: "If price continues to fall from its high today below both the medium term uptrend channel that connects July, Sept, and now Oct lows as well as 1,450, then shorts can be opened up with the assumption that 1,430 will be visited again."  And it was, as was 1,374, where we took short profits.

What's that you say about margins?

Like Icarus, analysts it seems are assuming earnings can go up forever into perpetuity.  But in reality, S&P earnings (SPY) are cyclical and are now starting to slow. They rise and fall over time based on normal macro cycles.  

There is easy justification for this cyclicality. When earnings rise, so do margins. When margins rise, competition steps in as barriers to entry are able to be overcome. Competition then puts pressure on pricing. This lowers margins and eventually earnings.  If there is any doubt to this economic fact, just research the Android (GOOG) versus Apple (AAPL) situation unfolding. 

Margin peaks: a few examples

Operating earnings margins peaked in the June 2012 quarter at 9.2%, where they also were in the December 2011 and March 2012 quarters. Now, margins have also started to decline down to only 9.0% in the September 2012 quarter. It remains to be seen, but it wouldn't be surprising given the recent earnings cuts that the December 2012 quarter will be below 9%, setting up a trend of now falling margins.

The same thing happened in 2007 near the previous market peak (IVV). Margins hit 9% in the September 2006 quarter and remained topped out between that level and 9.3% for the next year. Then in the September 2007 quarter margins declined to 8.9% and kept falling from there. 

The below chart from Deutsche Bank outlines the historical cyclical nature of margins. Earnings margins have risen and fallen throughout history, they have hardly been linear, and this is perfectly normal.

I am not one to assume "this time it's different" and am very cautious that earnings and margins at these elevated levels are not sustainable. We have already started to see the cracks forming in earnings, with only 1.2% expected growth over 2011 as well as the first decline in margin rates since 2009. 

A continued deterioration of margins would certainly bring down full-year 2013 estimates.

Icarus flew too high, earnings too

Given the market is at 30-year margin highs (matched only at the peak in 2007), competitors are currently stepping in, lowering prices, pressuring margins, and resulting in lower earnings estimates (see Apple).

Looking at the above chart, not only do we see the cyclicality of earnings margins but we also see that margins are higher than they have ever been since the early 80's when the data begins. Margins at over 8% are a reason to be earnings cautious, earnings over 9%, those are left for Icarus.


More from Minyanville

Feb 21, 2013 1:11AM

"Looking at the above chart, not only do we see the cyclicality of earnings margins but we also see that margins are higher than they have ever been since the early 80's when the data begins."


Looks to me like Wall Street mythology about not fighting the FED is real in both of your charts.


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