While the core of our investment thesis is derived from the field of behavioral finance, we continually monitor market fundamentals. Considering we are in the midst of corporate earnings season we thought it reasonable to take a deeper look at what the numbers seem to be telling us.

Wall Street is expecting the S&P 500 to produce just under $117 per share in the coming twelve months placing the twelve month forward P/E at around 14.5 times. This multiple is slightly elevated when compared to its long term average so it’s tough to buy into the extremely overvalued story.

That said, there is clearly more to the story than the static valuation figure. We wrote several weeks ago, in the midst of what was one of the most negative pre-announcement seasons on record that we would be watching closely the quality of earnings as reporting season commenced.

Earnings expectations remain at lofty levels while revenues are flattening. In order to meet these earnings projections, corporate profit margins will need to reach some of the highest levels on record. When revenues are flattening or declining, companies can expand margins through cost cutting, share buy backs and by borrowing earnings from future quarters.

We measure this “borrowing from future earnings” by utilizing our earnings quality model.

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EARNINGS QUALITY

Suppose we had two companies, Company A and Company B. Both are expected to earn $1.00 per share on $10mm in revenues. One would think them identical but that may not be the case. One needs to analyze the quality of earnings to get a clearer picture. Let’s suppose the “cash” component of company A is $0.80 and the “accrual” portion is $0.20. This means that of the $1.00 in earnings that is reported by company A, $0.80 is accounted for and collected as reflected on the cash flow statement and $0.20 is reported but not yet collected.

Now suppose the “cash” component of company B is $0.20 and the “accrual” portion is $0.80. Clearly there is a much greater risk of an earnings miss by company B.

Here is what we wrote at the start of 2Q13 earnings season. “Possibly the companies in the S&P 500 can meet these earnings projections by “borrowing” from future quarters to meet the current quarter. If that were to be true, then we would see deterioration in the earnings quality for the index.”

After running our model to capture earnings quality for the index, we found that to be the case. Since 3Q09, earnings quality has been breaking down and last quarter entered the “low earnings quality” area. This may be another reason there has been so much downward guidance for the coming quarter.

BOTTOM LINE

The large number of negative pre-announcements raised eyebrows and usually precedes a turning point in our earnings quality model. Should the slope of the line head higher with conviction, it is our opinion that we could see a major downward move in the U.S. equity markets.

Portfolio Note: We ended up selling our inverse market positions as the S&P 500 broke through its 50DMA and the 1630 levels with conviction. We took small losses on our trades as it appeared we were on the wrong side. We DID NOT take an active long position because it just isn’t the appropriate strategy. We will wait for further evidence of a market breakdown and step back in.  We believe this year will offer reasonable gains to the downside.