Elevated 2018 Estimates Widen Gap Between GAAP & Non-GAAP Earnings

Via Hedgopia.com,

As of last Thursday, a little over four-fifths of S&P 500 companies reported 2Q17 results.  Of the 422 companies, 70.1 percent beat on operating earnings, 20.6 percent missed and 9.2 percent met, as per S&P Dow Jones Indices.

In the latest week (through Thursday), 2Q17 estimates went up by $0.33 week-over-week to $31.03.  When the quarter came to an end, estimates were $30.97.  Going back many quarters, actual earnings have come in lower than expected at the time of the quarter-end.  From this perspective, the hitherto 2Q17 trend is an improvement, although one-fifth are yet to report.

The increase in 2Q17 estimates also helped push up 2017 estimates by $0.13, to $127.64, even as 2018 went down by $0.40 to $144.77.  More important perhaps is the revision trend, which is down.

In January last year, 2017 was expected to come in at $141.11.  In January this year, 2018 estimates were $147.21 (Chart 1).

The downward trend in 2017/2018 estimates is nothing new, considering how 2015 and 2016 fared.  In both those years, actual operating earnings were substantially less than the sell-side’s original estimates.

As things stand, 2018 expectations look way elevated.

There is a tight correlation between GDP and corporate profits.

U.S. corporate profits adjusted for inventory valuation and capital consumption peaked at $2.23 trillion in 4Q14, with 1Q17 at $2.11 trillion.  Since that peak, profits fell year-over-year in five quarters and rose in four, including gains of 3.3 percent in 1Q17.

Growth in real GDP peaked around the same time – in 3Q14, when the economy expanded at a 5.2 percent annual rate.  In 2Q17, it grew 2.6 percent.  This was higher than the post-Great Recession average of 2.2 percent, but much lower than the long-term average of 3.2 percent going back to 2Q47.

The economy is in its ninth year of recovery.  Expecting it to accelerate at this time is probably a risky bet.  That said, 2018 earnings estimates probably do exactly that.

Valuation multiples are priced off of these estimates.  Stocks are at/near all-time highs, with elevated multiples.  Using trailing 12-month numbers as of 1Q17, the S&P 500 traded at 21.3 times operating and 23.6 times reported earnings.

Hence another equally important question, how clean are these estimates?

Chart 3 plots both operating (non-GAAP) and reported earnings (GAAP) of S&P 500 companies going back to 4Q10.  (Except for the lighter-shade bars within the blue box, these are actual numbers.)

One distinct trend in particular since 4Q14 is that the gap between the two is widening.

Companies are required to report GAAP earnings, not non-GAAP.  Non-GAAP numbers are reported by the reporting company, but they do reconcile the two.

There are times companies have perfectly good reason to request/ask analysts/investors to ignore certain items.  Irregular or non-cash expenses or one-time charges, for example.

Restructuring expenses, stock-based compensation, goodwill amortization are some of the non-GAAP exclusions.  In general, this does tend to smooth out earnings volatility.

The problem arises when this becomes a permanent fixture.  Stock-based compensation among many tech outfits, for example.

Chart 4 subtracts operating earnings of S&P 500 companies from reported earnings going back to 1988.

The difference was minuscule at the beginning.  It began to grow circa 2000, and has stayed.  In both 2002 and 2008, GAAP took a massive hit, as assets got impaired, so both these years are more of an outlier.  But even excluding these, the trend is not getting better.  The discrepancy between GAAP and non-GAAP is not narrowing.

This raises questions about the quality of non-GAAP earnings, which is what the investing community in general focuses on.  This gap is easy to ignore in good times, but maybe not so when bad times hit.

Fewer Corporate Insiders Are Buying Their Own Stocks Than At Any Point In 29 Years

If "everything is awesome" then someone will have to explain to us why corporate executives are buying their own firms’ shares at the slowest pace in at least 29 years.  According to the Washington Service, there were a total of 279 insider buyers in January, the lowest since 1988.  Moreover, the number of sellers has also grown in recent months, pushing the ratio of buyers to sellers in February to its lowest since 1988 as well.

Meanwhile, Ned Davis Research points out that insider selling has been elevated enough to trigger his firm"s in-house bearish signal for 11 weeks in a row, the longest stretch since 2014.

Insider selling is generating a “sell” signal to analysts at Ned Davis Research Inc., a research firm that uses technical analysis. Insider selling at firms whose shares trade on the New York Stock Exchange, Nasdaq Stock Market and American Stock Exchange triggered its in-house bearish signal for 11 straight weeks, the longest stretch since 2014.

“The fact that we’ve gotten more selling is a sign of concern that maybe the market has gone a little too far too fast,” said Ed Clissold, chief U.S. strategist at Ned Davis. “We wouldn’t be surprised if there was a modest pullback given how far the market has run.”

Of course, as the WSJ notes, insiders sell stock for a variety of reasons, and often simply for diversification or to fund personal expenditures.  That said, when insider selling reaches the extremes we"re seeing today, it"s hard to imagine that valuations aren"t playing some role in the decision making process.

Insider selling can give mixed signals, too, and the absolute figures alone don’t themselves portend an imminent decline in stocks. Corporate executives can sell their stockholdings for many reasons, and selling generally outpaces buying regardless of market conditions.

“People sell for a variety for reasons, exercising options or buying a house,” said John Buckingham, chief investment officer at Al Frank Asset Management. “But generally there’s one reason to buy—you think your company is undervalued.”

During early months of any year, executives who received stock-based compensation are freed up to take money off the table, so selling tends to be higher, according to Ben Silverman, director of research at InsiderScore, a research firm.

Meanwhile, some of the largest sellers of the "Trump Rally" have been the executives running the biggest beneficiaries of that same rally, namely the wall street banks.  Morgan Stanley CEO James Gorman sold shares for the first time in six years just days after the presidential election, exercising options on 200,000 shares, and then sold an additional 100,000 shares later that month.

JP Morgan insiders have also been large sellers of the Trump rally...

...as have the folks at Goldman where insiders dumped 100"s of thousands of shares right after Trump"s election and have continued to sell heavily ever since.

Meanwhile, BAML is the only wall street bank that seems to have faith in the Trump rally. 

Could it be that maybe everything is not all that awesome after all?