Where have the profits gone? 2014 is, for the moment, the fourth year of substantial downward revisions to the estimate of earnings growth in Europe. Goldman Sachs points this out in a recent report entitled “Where haveall the earnings gone?” noting that at the beginning of the year a growth of 13% was expected and now the consensus stops at +7%. Not only. These downward revisions have been made on a massive scale: few sectors have remained immune to them. Not that downward revisions are the exception. On the contrary. Apparently they are the rule: since 1989 more than 60% of months have seen negative reviews. On the other hand, corporate reviews are well anchored in macro data and GDP reviews. Thus, in light of the recent drop in estimates of world GDP in the first half of the year, Goldman Sachs has also revised its forecasts for EPS growth in Europe (earnings per share) to 6% from 11% in 2014.
It is therefore legitimate to ask whether the rally in price lists will be able to withstand these continuous cuts. For Goldman Sachs there is room for hope: “Past negative profit revisions have not precluded equity rallies. Additionally, Q2014 1,5 earnings are starting to grow albeit at a mediocre (+XNUMX% QoQ).” Let's see the main points of Goldman Sachs' analysis.
REVISIONS ARE THE NORM
Negative reviews are the norm rather than the exception. More than 1989% of months since 60 have seen negative reviews. It is usually only later in the cycle that revisions move into positive territory. Analysts compare earnings estimates one year apart and find that it is not unusual for them to be revised significantly up or down during the year: the average variance, in absolute terms, is about 14 %. “The difference – they add – is not equally distributed between positive and negative reviews. Years with negative revisions outnumber those with positive revisions by about 2 to 1. We also found a connection between profit revisions and profit growth.
GUILT OF THE REVISION OF THE GDP
Goldman Sachs notes that the revisions are tightly correlated to GDP revisions with a sensitivity estimate of around 10x. The recent episode of cutting earnings forecasts can also be linked to the trend in gross domestic product expectations. For analysts, it is interesting to note that the figure is very close to the sensitivity of profit growth compared to GDP growth, estimated at 10,5 in a previous study by Goldman Sachs (Profit Pathology: A macro investor's guide to the European profit cycle, April 4, 2014).
LIMITED IMPACT ON THE PRICE LISTS
Historically, negative revisions have little impact on overall market performance as stocks can rally even as earnings expectations are lowered. “Overall – writes Goldman Sachs – the contemporary link between performance and the earnings revision is weak. This is because investors anticipate the recovery in profits and shares are at least initially buoyant even while earnings are still being revised down.
EARNINGS ARE IMPROVING
With the earnings consensus continuing to fall, Goldman Sachs notes, it is tempting to question the actual move into the growth phase. “In any case – the analysts retort – while profit estimates continue to be revised downwards, actual profits have started to grow again since the last quarter of 2013”. However, this growth was slow, around 1,5% quarter on quarter, also due to the low level of economic activity recorded in the first quarter both in the USA and in China. "To hit our growth estimates, we need to see sustained improvements in economic indicators and an acceleration in profit growth in the second half of the year."
EARNINGS ESTIMATES REVISED DOWN. EPS AT PRE-CRISIS LEVELS ONLY IN 2016.
The modest improvement in reported earnings therefore suggests a recovery in profits albeit at a slower pace than the consensus expected. For this reason, Goldman Sachs analysts have decided to revise downwards their GDP growth estimates for the USA, China and the euro area for 2014, to 2,5%, 7,3% and 1% respectively. “Furthermore – they add – the strength of the euro since the beginning of the year has been a brake on European revenues with negative surprises on sales”. So the broker also revised downwards its 2014 earnings growth estimates to 6% from 11%. Forecasts unchanged for the following years instead: +12% in 2015, +9% in 2016 and +8% in 2017: the weakness in the first quarter of 2014 is expected to be temporary because it is due to the climatic conditions especially in the USA. "Recent improvements in US growth are encouraging," says Goldman Sachs, leaving the Stoxx Europe 600 index price targets unchanged over 3, 6 and 12 months at 350, 360 and 375 respectively and expects a further slight expansion of the multiples next year to 14,7 from 14,4.
“While our revised estimates may sound optimistic in light of the negative revisions we have seen over the past three years, they continue to point to a slow recovery in profits with the level of European EPS reaching its previous 2007 peak at €27,9 in just 2016”.
