In Reality, Earnings Are Falling: Bad News For Bulls

Based simply on CAPE (cyclical adjusted price to earnings) the market is significantly overvalued with a reading of 23.

However, even this measurement understates the true nature of the bubble because one of the biggest drivers of corporate earnings in the post-2009 era is financials (they account for 16.8% of the S&P 500, second only to IT). And financials’ earnings are a complete fantasy derived via accounting gimmicks.

I’ll give you an example. One of the classic accounting gimmicks is to write off loan loss reserves.

Banks and other financial institutions are required by law to maintain a certain amount of capital to make up for loans that borrowers default on. No matter how hard a bank works to only lend to those who won’t default, inevitably a certain number of loans go bad.

Loan loss reserves are expensed against earnings. So when you raise loan loss reserves, your profits fall (profits= sales-expenses). And in contrast, when loan loss reserves fall earnings are higher even though the bank hasn’t technically made more money.

JP Morgan used this tactic to juice its first quarter earnings for 2013 by a whopping $1.2 billion. Without this gimmick, earnings were only 8% higher than those of first quarter 2012, not the incredible 33% JP Morgan claimed by lowering loan loss reserves.

This is just one of a numerous accounting gimmicks financial companies use to juice earnings higher. But it’s a very safe assumption to state that financials’ earnings are imaginary in nature.

So, let’s take financials out of the mix. Unfortunately for the bulls, financials are the largest contributors to earnings growth for the S&P 500 in 2Q13. If you remove this sector, then earnings for the S&P 500 in the second quarter so far are DOWN 2.9%

This is the most critical issue for the US stock market, not who will be the next Fed Chairman. Earnings are the primary drivers of markets.