A Disturbance in the Farce

Corporate revenues and earnings have been weak for quite some time. In big cap stocks this has been masked by the stock buyback effect, which supports earnings per share, even if the underlying trend of a business sucks. Unfortunately, stock buybacks are a horrible use of capital when stocks are trading at bubble valuations. Ironically, managers of listed companies have a great knack for boosting buybacks to record highs right when prices are at their peak. After a crash like the one in 2008 when prices are actually cheap, buybacks tend to dry up almost completely.

Image credit: George Lucas

Moreover, many companies are levering up their balance sheets to finance these buybacks. So not only are they buying at absurd prices, they are incurring a mountain of debt to do so. Corporate debt has rushed from one record to the next in recent years. Future regret is absolutely guaranteed.

Hitherto, the stock market has largely ignored weak earnings and so-so guidance. However, it seems the patience of investors is running out, in spite of the fact that money supply growth remains brisk and in spite of the incessantly repeated mantra of the “magical second half” in which the economy is held to finally attain “escape velocity” – whatever that is actually supposed to mean (apparently many economists believe the economy is a space-ship).

Further below is a chart showing the stocks of three companies of very different quality. The first is IBM, a company in which Warren Buffett inexplicably bought a large stake just as its stock price was close to peaking. IBM’s main claim to fame is its mastery of accounting trickery, which has served it quite well while its actual business was slowly but surely going down the drain. Zerohedge recently posted an article about IBM’s seemingly inexorable collapse in revenues – we reproduce the chart of its quarterly revenue growth data below:

IBM’s quarterly top-line growth, via Zerohedge. This looks quite atrocious, especially considering we are in a “recovery” – click to enlarge.

IBM has gotten away with its mediocre business performance for a long time, not least because it has bought back its own stock by the truck-load, keeping a rising trend in earnings per share alive. Alas, its balance sheet has become a lot less appealing as a result.

The second company is the highest quality one of the three, namely AAPL – it disappointed slightly on earnings and revenues last night, as well as on guidance. However, Apple continues to enjoy solid support from Wall Street analysts, so it is not certain whether the overnight downturn in its share price will even be sustained. What is remarkable is only that it has been down at all. To be fair, AAPL is still quite conservatively valued compared to the overall market.

The third company is known as the “ flying pig”, a sobriquet given to it by Fred Hickey and Bill Fleckenstein. MU (Micron Technology) is in a really crappy business, namely DRAMs. However, against all odds, its stock has been able to levitate for a long time. This is no longer the case.

Three recent examples of the market reacting negatively to earnings and/or guidance disappointments – click to enlarge.

Conclusion

It’s still early days in the current earnings season, and in recent quarters the market has always been able to dodge the bullets. However, we do get the feeling that a bit more attention is being paid to weak results this quarter than has been the case previously – at least so far. If so, then the market could easily get into trouble. The strong dollar still affects the earnings of multinational companies negatively, and the domestic economy isn’t much to write home about either.

Google has delivered a strong earnings report, and has been rewarded with a multi-billion dollar jump in its market cap. However, this may well turn out to be the exception to the rule this quarter. All companies that have sizable business in China are likely to report disappointing results from the region, and while European economic activity is perking up as capital malinvestment and consumption surge under the ministrations of serial money printer Mario Draghi, the absolute numbers actually remain pedestrian at best.

The strongest argument in favor of a continued rally in the stock market remains money supply growth in the US and Europe, which is still reasonably strong in the former (with TMS-2 growing at more than 8% y/y), and absolutely insane in the latter (with money TMS growing at nearly 14% y/y by now). However, weak earnings could at least temporarily dent the party. There is one sub-sector of the market that continues to do very well however: the stocks of distinctly profit-less rivers of no return such as AMZN, TSLA and NFLX keep levitating.

It is a kind of flight forward by investors – promises of future returns that may or may not eventuate (in AMZN’s case “may not” seems most likely, based on its historical performance) continue to be highly rewarded – no price seems too high. This is actually a fairly typical bubble phenomenon. It is impossible to say for how long it will continue and how far it will go, but it is possible to say how it will end: in tears, especially for Johnny-come-lately investors.

The market’s profit-less wonders continue to produce astonishingly good returns for their shareholders – for now – click to enlarge.

Charts by: ZeroHedge, StockCharts