After the recent sharp spike higher in the S&P which has pushed it 150 points off its lows, the market may be down 3% since the beginning of the year. However, while many have blamed the 2016 selloff and subsequent rebound on central bank policy confusion, what many are forgetting is that a key factor pushing stocks lower are corporate earnings. And, as JPM reminds us, even with stocks 3% lower for the year, the overall market is more expensive now than it was at the start of the year.
As JPM's Mislav Matejka writes, "equities are down ytd, but notably the ’16 P/E is not much cheaper today than it was at the start of the year. In fact, for the US, the P/E multiple is currently higher than it was on 1st January, at 16.8x vs 16.6x then. For MSCI World, P/E is flattish vs Jan as the ’16 EPS has been revised lower by 5% so far ytd."
All of this is based on non-GAAP earnings, and as a reminder in recent months - culminating with Buffett's most recent letter - there has been an increasing revulsion to the use of non-GAAP, or "gimmicked" accounting. Bloomberg said as much recently:
It’s generally accepted that a lot of accounting isn’t, well, generally accepted. But with more and more companies promoting bookkeeping that deviates from U.S. standards known as GAAP, for Generally Accepted Accounting Principles, the Securities and Exchange Commission is warning about getting too creative.
The concern is too much non-GAAP accounting could make it harder for investors to size up companies -- a risk that was driven home during the Nasdaq boom of the late 1990s and more recently at Groupon Inc., which before going public used profit measures that stripped out some of its biggest costs. Groupon has mostly lost money and market value ever since.
Using non-standard accounting is perfectly legal, provided companies also report the official GAAP numbers. These days, young companies aren’t the only ones offering up two sets of books.
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While creative accounting has been around forever, non-traditional measures -- “metrics,” in industry parlance -- have been on the rise lately. Companies routinely highlight the non-GAAP results in press releases that announce earnings, and Wall Street analysts often fixate on the adjusted figures. The number of companies in the Standard & Poor’s 500 Index reporting non-GAAP results rose to 334 in 2014 from 232 in 2009, according to research from The Analyst’s Accounting Observer.
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In his latest shareholder letter, Warren Buffett disparaged the omission of pay as “the most egregious” example of non-GAAP accounting. “The very name says it all: ‘compensation,”’ he wrote in his annual letter posted online Saturday. “If compensation isn’t an expense, what is it? And, if real and recurring expenses don’t belong in the calculation of earnings, where in the world do they belong?”
This follows an article which we penned over the weekend in which we showed that while non-GAAP earnings remain relatively flat, if down Y/Y for three consecutive quarters, it is the GAAP data where the pain is manifesting itself, and as of December 31, the S&P's GAAP earnings are poised to record the lowest profit since 2010!
We also showed that the spread between GAAP and non-GAAP is now the highest since the financial crisis.
What we find disturbing, however, is that while many mainstream media outlets will decry the use of non-GAAP earnings, few will say what this actually means. we had no such qualms, and explained it very simply: : "if using GAAP earnings, and applying the market's already generous 16.5x non-GAAP P/E, one gets a fair value of the S&P 500 of 1,500, or 25% lower than the recent prints in the S&P 500."
This would make the market the most expensive it has been since 2008.
Perhaps the closest anyone has gotten to admitting this is again JPM which in passing, notes the reason why it refuses to buy the market.
Earnings rollover is the key headwind to buying the market outright over the medium term horizon, in our view. EPS revisions remain deeply negative in most regions. The weakness in PMIs is suggesting this will stay the case.
And as Factset explained over the weekend, it is only going to get worse: for Q1 88 companies have issued negative EPS guidance and 22 companies have issued positive EPS guidance.
In other words, while non-GAAP P/Es are set to rise even more making the market the most expensive in months, it is the GAAP EPS which are confirming what virtually nobody dares to mention - when one strips out the "creative accounting" the market is about to return to 2009 levels in profitability, and to a GAAP P/E multiple that will soon surpass even that seen at the peak of the 2008 financial crisis.
Which may also explain why over the past five years the "smart money" group of hedge funds, financial institutions and private investors have been dumping stocks at a torrid pace to the only buyer willing to step up: corporation themselves who have unleashed what is set to be another record, and completely price indescriminate, buyback spree funded by cheap "investment grade" bonds.