Have companies in the key stock indices mastered the trick of luring investors into buying their stocks? On the surface, the profits at public companies seem to be rising. But when you dig deeper, you find massive financial engineering. Corporate earnings aren’t growing organically or by acquisition. Companies aren’t selling more of their products. They are reducing the number of shares they have outstanding to make per-share earnings look better.
Consider this: as of November 14, 462 of the S&P 500 companies have reported their corporate earnings for the third quarter of 2014. Of those companies, only 59% reported sales that matched or bettered their estimates. (Source: FactSet, November 14, 2014.) To help promote earnings growth (because they lack sales growth), companies are either cutting costs or buying back their shares.
JPMorgan Chase & Co. (NYSE/JPM) is planning to reduce its workforce by 7,000 by the end of this year. The layoffs will occur in the company’s mortgage banking, and consumer and community banking units. By 2016, through this cost-cutting measure, the bank expects expenses to be $2.0 billion lower. (Source: The Wall Street Journal, November 7, 2014.)
Likewise, Sprint Corporation (NYSE/S) is planning to reduce its workforce by 2,000 employees. (Source: CNN Money, November 3, 2014.)
Cost-cutting helps companies earn similar or even higher profits, even if their revenues fall.
In addition to cost-cutting, a significant number of companies on the key stock indices are buying back their shares to boost per-share earnings. I’ve discussed this phenomenon many times in these pages. As companies buy back their shares, their earnings per share—what the mainstream cares about the most—look better, even if operational profits decline. And, it helps make losses appear smaller.
In the second quarter of 2014, S&P 500 companies purchased $123.7 billion worth of their own shares. In the trailing 12-month period, stock buybacks by the S&P 500 companies have totaled about $540 billion, up 29.4% from the previous trailing 12 months. (Source: FactSet, September 17, 2014.)
Over my investing career, I have learned that in the short term, “tricks” and irrationality work. But in the long term, it’s the fundamentals that actually matter. Remember the Internet bubble of the late 1990s? Investors were buying companies that had no revenues and their stock prices rose significantly. Soon enough, the prices of these stocks came crashing down. Many of those companies went out of business and were delisted from the stock market. Investors who bought into the hype were left with huge losses.
Today, investors are losing sight of the big picture again, as irrationality currently prevails in the markets. And that makes stocks very risky.