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 Forecasting America's Destiny ... and the World's


Generational Dynamics Web Log for 9-Mar-08
First quarter corporate earnings growth estimates start falling

Web Log - March, 2008

First quarter corporate earnings growth estimates start falling

It's time to place your bets, ladies and gentlemen: where will it end up?

Recall that we've been following the official analyst estimates of fourth quarter corporate earnings. The last time that we looked at them, a few days ago, they were at -25.2% -- that is, 25.2% lower than last year. At the beginning of the quarter (on October 1), the experts had estimated that they would GROW by 11.5%, but we watched these estimates fall, week after week after week.

Well, now we're ready to start following the earnings growth estimates for the first quarter of 2008.

Quarterly S&P 500 earnings growth, 2000-present, with estimates for Q4 and for 2008 -- as of October 23, 2007.
Quarterly S&P 500 earnings growth, 2000-present, with estimates for Q4 and for 2008 -- as of October 23, 2007.

Let's begin with the adjoining graph, that I originally posted last year on October 23.

At that time, the asset writedowns were just starting. Analysts had predicted double-digit earnings growth for the 3rd quarter, but by October 23 it was clear that earnings growth was going to fall sharply.

Asset writedowns -- the kind that we've been hearing over and over again -- were just beginning, and they were bring earnings down. Bubbly financial analysts were saying that the third quarter would be a "kitchen sink" quarter. What they meant is that financial institutions would pack all their writedowns and any other losses into the third quarter report, so that they could go back to double-digit earnings growth in the fourth quarter.

As you can see from the above graph, that's what they were expecting. The graph shows that earnings growth for the 4th and 1st quarters were estimated at that time to be around 10%.

And so, we start from there: The 1st quarter earnings estimate as of October 23 was 10%.

And now, the CNBC earnings central page has change from 4Q earnings to 1Q earnings. Here's summary from Friday, March 7, from CNBC Earnings Central:

"As of Friday, March 7th: ...

The blended earnings growth rate for the S&P 500 in first-quarter 2008, combining actual numbers for companies that have reported, and estimates for companies yet to report, fell to -4.3% from -1.1%, due in part to downward estimate revisions from Citigroup and AIG.

On January 1st, the estimated growth rate for Q1 was 5.7%. (Data provided by Thomson Financial)"

This summary provides us with three different numbers, the estimates as of January 1, the estimates as of a week ago, and the estimates as of Friday. We can put this into a table:

  Date    1Q Earnings estimate as of that date
  ------- ------------------------------------
  Oct 23:             +10.0%
  Jan  1:              +5.7%
  Feb  6:              +2.6%
  Feb 29:              -1.1%
  Mar  7:              -4.3%

So what do you think, Dear Reader? Do you think it will stabilize at around -4 or -5%? Or do you think it will fall to -25.5% like last quarter? Or maybe even lower? Ya places yer bets and ya takes yer chances.

Analysts are still fantasizing that earnings growth will return to double-digit values. However, earnings have been growing much faster than average for the last 12 years, and so by the Law of Mean Reversion, their growth will have to be equally below average for roughly the next 12 years.

Now here's something interesting.

There's a price/earnings ratio chart at the bottom of this web site's home page, and it gets updated automatically every Friday. Here's the March 7 version of the chart:

S&P 500 Price/Earnings ratio and S&P 500-stock Index as of 7-Mar-2008. <font face=Arial size=-2>(Source: MarketGauge ® by DataView, LLC)</font>
S&P 500 Price/Earnings ratio and S&P 500-stock Index as of 7-Mar-2008. (Source: MarketGauge ® by DataView, LLC)

The top part of the above chart provides the P/E ratio, and the bottom part of the chart provides the S&P 500-stock Index.

Now, notice the following:

When you put these two facts together, what you see is that investors are following a formula: They're buying or selling based entirely on earnings, keeping the P/E ratio at 18. Putting it another way: The P/E ratio is remaining constant; therefore, P goes up when E goes up, and P goes down when E goes down.

And so, when you look at it that way, the S&P graph is actually the same as the graph for corporate earnings, when the scale is adjusted.

Well, I think this is a remarkable fact, and it's even obvious, but you never hear anyone talk about it.

Nor does anyone talk about the fact that earnings evidently are continuing to fall, and this means that the stock market is going to continue falling.

The Law of Mean Reversion applies to earnings, as we've said, and indicates that earnings are going to remain below average for many years.

But the same Law of Mean Reversion also applies to the P/E ratio index, and I explained in "How to compute the 'real value' of the stock market."

During the bubble days, we had a double-bubble: bubble earnings combined with bubble P/E ratios. Now we have a double-trouble bubble-bursting. Earnings are falling, but P/E ratios are also going to fall sharply, probably to the 0-5 range. This portends a 90% stock market collapse (same as 1929-33) to the Dow 1500 range.

It remains a puzzle when all of this is going to happen. I've given up trying to estimate a date, Now I just use a kind of "safe harbor" by saying that I've estimated that the probability of a major financial crisis (generational stock market panic and crash) in any given week from now on is about 3%. The probability of a crisis some time in the next 52 weeks is 75%, according to this estimate.

Having established this safe harbor, it still remains a subject of endless fascination to try to at least guess what the triggering event will be for this generational panic and crash, the first since 1929. It's folly to try to predict any chaotic event (in the sense of Chaos Theory), but it's irresistible. And don't we all occasionally do some things that are folly but irresistible?

What I've been particularly watching for, as I've said a number of times, the thing that triggered the 1929 crash: A domino effect, where market losses lead to margin calls, which lead to forced selling of stocks to get cash to meet the margin calls, which causes more market losses, in a vicious circle.

As I described in the article I posted yesterday, there appears to be something different happening this time: This vicious circle is already occurring in the bond market, a result of the "credit crunch" that began last August. With Wall Street markets now at 73 week lows, with markets in Asia and Europe also falling sharply, we may be very close to a stock market panic and crash. But the underlying driving force appears, at this time, to be a slow-motion panic, already in progress, in the "utterly unhinged" bond market.

The Wall Street Journal has posted an article headlined, "March may be quite cruel," which indicates that this bond market panic is going to get a lot worse in March:

"Some ailing companies are bracing for their own March madness.

It is the time of year when companies, as some deal makers say, "open the kimono," revealing to lenders year-end audits, budget projections or income-statement forecasts. These often give lenders an early glimpse of trouble ahead, a warning that a loan agreement could be violated or that a borrower will need more credit.

This year's meetings are likely to be a lot more tense than in recent years, bankers say. Credit and patience are in short supply, as banks try to husband capital and jettison underperforming loans.

"We are hearing from lenders who are wondering how much they should push a reluctant client to restructure. They are asking, 'Should I push to liquidate it now so I lose X, because if I wait six months I might lose 2X,'" said Vince Lambiase, managing director with Michigan-based restructuring firm BBK.

In the past week, jumbo-mortgage lender Thornburg Mortgage Inc. of New Mexico was pushed to the brink of a bankruptcy filing after lenders demanded $270 million in margin calls. Margin calls force borrowers to repay loans or put up more collateral to secure them.

Likewise, a growing number of lenders will this month push borrowers to choose among several painful options -- such as seeking a bidder to buy all or some of the company, undertaking a massive restructuring or finding an investor to inject more capital. If those choices don't work, that could mean new bankruptcy filings.

Sometimes called line-renewal season, March marks more than the start of college basketball's frantic championship tournament. It is the third-busiest month for corporate-bankruptcy filings over the past 16 years, according to research firm December and January rank higher. ...

The tightening of credit by once-patient lenders is why Standard & Poor's and Moody's Investors Service have projected corporate defaults to grow fivefold or more from the record lows of 2007.

Moody's on Tuesday estimated about $48 billion in speculative-grade corporate bank loans will mature between now and 2010, the majority of that next year and the year after. Moody's predicts corporate default rates to jump to 5.3% in 2008, up from less than 1% in 2007."

This analysis indicates that the "credit crunch" anxieties are going to get much worse during March -- as has already been the case so far in March anyway. Perhaps my 3% estimate should be increased to 4%, 5% or 6% for each of the remaining weeks of March. Referring back to my description in the the article where I described the 3% estimate, at 6%, that would equal the probability of tossing four coins in the air simultaneously, and having all four coins come up heads.

In any event, the important concept is that this bubble-leaking process is not reversible. This is a "wasting process," meaning that it's gradually destroying what's left of the world financial system. People who hope that some "bottom" will be reached, the bubble will start reflating, and the health of the world financial system will be instantly restored are dreaming.

I've used an analogy of a bloated mansion several times in the past. Here's how I described it in November:

"Think of the world economy as a huge, enormous bloated mansion made of wood, with all kinds of additions tacked on all over the place. Think of the CDOs as millions of termites that are eating away at the insides, so that another piece of the mansion falls off into the ravine almost every day.

The Fed and other central banks have been running around the mansion with hammers and glue and nails, patching things up as fast as they can, trying to keep ahead of termites. They've been pretty successful with their hammers and glue and nails in postponing the inevitable, even bloating the mansion up a little more, but they can't keep up with the termites.

[What's happening] is that the hammers and glue and nails aren't working, and it won't be long now before the entire mansion collapses into the ravine."

A web site reader has commented on this analogy with respect to a technical argument having to do with yield curve steepening (which occurs when long-term interest rates grow while short-term interest rates decrease):

"I see a psychological dynamic now that is similar to what you are seeing where analysts and investors are trying to find reasons that "this isn't really happening." An example of another theory out there is that the yield curve is steepening and there will be "balance sheet repair" going on from here on out.

It reminds me of your mansion analogy, except for the belief that the outcome will be a brand new mansion that cannot possibly collapse. What they don't understand is that, if we use the mansion analogy, this "balance sheet repair" is being accomplished by pilfering material from other rooms in the mansion to remodel one room and that the whole mansion will collapse into the ravine anyway."

Of course there WILL be a brand new mansion -- but not right away. When the bloated mansion collapsed in 1929, it took almost 25 years to rebuild that mansion and create a shiny, brand new world financial system. That financial system was made up of many new and important innovations -- new public averseness to abusing credit, new regulations like Glass-Steagall Act, new agencies like the Securities and Exchange Commission (SEC), even new worldwide organizations like the Bank of International Settlements, the World Bank and the International Monetary Fund.

But all the advantages of these major innovations have been wiped away by generational changes. Young generations, born after World War II, have no averseness to abusing credit; 1930s regulations have been either ignored or repealed; the SEC has totally failed in its primary function of preventing a new 1920s-like bubble; and world organizations like the World Bank and IMF are mired in scandal and bureaucracy.

We can look back 15 years and ask, "How is America different today than it was in 1993?" We can point to many differences, but those are minor compared to the major continuities that have continued during that period.

Today we're facing major discontinuities -- a devastating worldwide financial crisis, causing massive poverty, unemployment, starvation and homelessness, and a devastating new world war that will kill 2-3 billion of the 6.5 billion in the world's population today. Looking 15 years ahead from now, the world in 2023 will be a completely different place with almost no resemblance at all to the world of 2008. (9-Mar-08) Permanent Link
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