Are the Dow and S&P 500 in the Midst of a Smoke-and-Mirrors Rally?

Following Friday's huge romp higher in the iconic Dow Jones Industrial Average (^DJI 0.25%) and broader-based S&P 500 (^GSPC 0.97%), both indexes are now up 20.3% and 24.1% year to date, respectively. With these returns more than doubling than historical average return of the market over the past century, my skepticism of this rally is greater than ever.

Source: Herval, Flickr.

However, it would be completely foolish of me to ignore that certain aspects of the economy haven't improved by leaps and bounds since the height of the recession. The unemployment rate has dipped from a high of 10% down to October's reading of 7.3%, signaling that people who want work are having an easier time finding a job. The housing industry has also been a bright spot for the U.S. economy, with years of record low interest rates and tight inventory control by homebuilders creating a situation where home prices have been moving steadily higher (12.8% higher in the latest 20-City Case-Shiller Index monthly report). Banking liquidity has also improved, with many U.S. banks likely able to survive an economic downturn with ease.

Yet other aspects of the economy haven't seen much improvement. Despite the drop in the unemployment rate, much of the new job creation this year has been part-time in nature rather than full-time work. Also, Congress' ongoing ability to strike bipartisan agreements has been practically nonexistent and thrust the U.S. government into an unwelcome 16-day shutdown last month.

The proof is in the pudding
But nothing stands out as more worrisome to me than the lack of organic corporate earnings growth in this country. To prove my point, I turn to research firm FactSet, which on Friday released its earnings insight report (link opens a PDF file) for the third quarter for companies in the S&P 500. Needless to say, I found plenty of fuel for my skepticism hidden within its report.

To begin with, of the 446 S&P 500 companies that have reported earnings in the third quarter, 73% have topped EPS projections. This is perfectly in line with the four-year average (73%) and slightly above the trailing four-quarter average of 70%. However, when we move onto revenue projections, just a paltry 52% of companies have managed to top estimates, which is below the four-year average of 59% but slightly higher than the trailing four-quarter average of 48%.

If you want, you can place some blame on Wall Street analysts that are doing just as much "guestimating" with their projections as we do as investors. Go right ahead. But keep in mind that Wall Street analysts more often than not are going to be quite conservative with their projections, so it should concern investors when roughly half of all S&P 500 companies miss them.

Second, even though 73% of companies topped estimates, the scope of earnings beats is shrinking. In the third quarter, according to FactSet, corporate EPS have topped estimates by just 1.8% compared with the trailing four-quarter average of 3.7% and a four-year average of 6.5%. In fact, the S&P 500's 1.8% average beat is its lowest since the financial crisis in 2008. FactSet blames the weak performance on the financial-sector stocks for this underperformance, but I'd contend it's a problem among nearly all industries.

Finally, FactSet notes that earnings growth estimates for S&P 500 components in the fourth quarter have dropped in the roughly five-plus weeks since earnings season began to 7.3%, from prior projections of 9.7% growth. Revenue, on the other hand, is expected to move higher for the S&P 500 by just 0.7%!

Source: Steven Depolo, Flickr.

A corporate smoke-and-mirrors campaign
How are companies achieving such paltry revenue growth yet boosting their bottom line? Simple: a smoke-and-mirror campaign filled with steep cost cuts, including job cuts in some cases, and sprinkled with hefty share buybacks meant to reduce shares outstanding and mask a lack of genuine organic growth.

Don't believe me? Let's look at some prime examples within the Dow Jones Industrial Average and S&P 500.

Within the S&P 500, I believe biotechnology giant Amgen (AMGN 0.08%) serves as a stark example of how buybacks can mask generally uninspiring growth. Amgen announced a $10 billion stock repurchase program in 2011, but it chose to partially find this buyback with debt -- a no-no in my book! The end result, on top of Amgen's ongoing efforts to repurchase its shares over the years, is that Amgen reduced its outstanding share count from 1.26 billion shares in 2005 to just 768 million shares today.

But over that time span, net income has improved from $3.67 billion to only a trailing 12-month total of $4.85 billion. EPS are up 115% over this same period, but revenue growth has trailed at just 46% over the past eight years. Although Amgen may have something cooking with its purchase of Onyx Pharmaceuticals, the real story here is that it's tried to cover up its mid-single-digit growth rate with uninspiring shareholder incentives -- and investors have completely bought in, sending its share price higher by 84% in that eight-year period.

If you think a smoke-and-mirrors cost-cutting and share-buyback campaign will work only with slower growth companies in the Dow, think again, because ExxonMobil (XOM -3.50%) has been masking sluggish income and revenue growth for years. Please keep in mind I'm not trying to take away anything from ExxonMobil's impressive free cash generating capabilities, but since 2005 its total revenue has improved only 20% to a trailing $443.7 billion, while net income is actually down 5% over the trailing 12-month period relative to 2005. Yet over this same period, ExxonMobil has repurchased nearly 1.9 billion shares, about 29% of its outstanding share total, and shares have advanced by more than 120%!

What's wrong with cost-cutting and share buybacks?
In a relatively strong growth environment, I wouldn't even bat my eye at a company cutting costs to improve its operating efficiency. The same would go for companies offering a dangling carrot to shareholders in the form of a share buyback.

However, I do have a big problem with it in the slow growth environment we're in now, because cost-cutting doesn't provide a path for sustainable EPS growth. Eventually, investors are going to catch on to the fact that organic revenue growth isn't there as EPS beats become smaller on a quarter-over-quarter basis, and when they realize that, this rally will probably come to a grinding halt.

I've tried previously to call a top in the market, and I've been wrong on practically every occasion, so don't take this as a signal to retreat to a cave with your money in a duffel bag. But do consider it as an advanced warning that corporate earnings growth is nowhere near as rosy as it appears. This year's huge rally in the market, which is based on perceived EPS growth, could be founded on nothing more than short-term cost-cutting and share repurchases -- hardly anything that would make me feel comfortable about putting my money to work in the market at this very moment.