Mind the gap between reported and "adjusted" earnings

Second quarter earnings season is now ending with nearly 75% of US companies having reported earnings better than the consensus expected. Before we get too excited about this outcome though, it is important to take a realistic view of the numbers.
First, as I have noted before, most of the positive earnings “surprise” last quarter was a direct product of two key features: drastically reduced analyst expectations (that were easy to beat), and heavily slashed expenses (which will be hard to repeat).
Euphoria based on such narrow results is sorely misplaced. Evaporating demand is the over-arching theme that the market rally has so far been ignoring. Industrial revenues dropped 20% year over year in the second quarter, and more worrisome looking forward was a 30% drop in new orders. Sales are still falling and based on this week’s poor data on retail sales, weak consumer confidence, and rising un-employment, sales are not likely to bounce back substantially anytime soon. See WSJ: Industrial Stocks living in the past.
Weak demand is a major problem for forward profits. Not only will they be harder to find now that costs have already been slashed, but over-supply/ over-capacity across the world’s export nations will continue to put downward pressure on prices and margins.
And there is something else. There is presently an ominous gap between Q2 reported earnings and adjusted operating earnings. Reported earnings are governed by GAAP. But adjusted operating earnings are at the discretion of management and exclude many expenses such as write-offs. Write-offs are at record highs and so are exclusions. This has led to a record gap between the reported earnings and the adjusted operating earnings. This gap is a black cloud over future earnings. Studies suggest that $1 of exclusions in a quarter predicts $4.17 less of cash from operations over the next three years.
“Today reported earnings per share for the S&P 500 companies gathered by Standard & Poor’s is $7.20 per share, down 91 per cent from the 2007 peak. On an adjusted operating basis, earnings are down 34 per cent [just] from the 2007 peak. This $54 gap is a record.”
See FT: Insight: Cause for caution on US earnings.
Earnings growth needs increasing profit margins, increased inventory turnover or increasing leverage. Increased leverage is unlikely in a de-levering world. Increased profit margins are unlikely for some time. Higher inventory turn-over may also be tough without expanding credit.
Despite recent sprinting in the stock market, this recovery is likely to be a marathon with many hills.
Bad debts and bad assets aren’t just in the financial sector and they will have to be accounted for eventually. Pretending they aren’t there is unlikely to work indefinitely.
For a good update on bad loans and pending write offs in the US banking sector watch this recent clip with Elizabeth Warren, Chair of the US Congressional Oversight Panel (COP). While you watch, keep in mind that Europe, the UK and some emerging economies are likely to have bigger write-downs and write-offs than the US.

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