Why earnings expectations may be too hopeful

Investors should attempt to isolate non-recurring items (both positive and negative) when evaluating the performance of a company or an index. The goal is to get a clearer idea of core, recurring earnings power before all the noise that can distort the true picture. This is important because management teams are notorious for using financial engineering to achieve their financial targets.

Traders work the floor of the New York Stock Exchange.
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Traders work the floor of the New York Stock Exchange.

Why would management teams want to do this? Well that's pretty obvious.

First, incentive compensation is often tied to the achievement of goals such as earnings growth, book value growth, returns on equity, etc. And second, management teams tend to own a lot of stock in the companies they manage. If earnings come in better than the underlying fundamentals would suggest, stocks prices can react more positively than they otherwise would. So today I'd like to attempt to defend Farr, Miller & Washington's cautious intermediate-term earnings outlook.

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According to data obtained from Standard & Poor's, operating earnings for the S&P 500 will increase close to 11 percent this year. If achieved, S&P 500 operating earnings will have grown at nearly a 16 percent annual rate since the financial-crisis trough in 2008. While this outsized EPS growth rate primarily reflects a rebound to the levels prior to the financial crisis, earnings have also benefited significantly from unusual items that should not be considered an accurate reflection of the true economic value being created.

Speaking in wide generalities, of course, companies have squeezed nearly every drop of juice from a very slowly growing fruit which, in this case, represents top-line revenue. In addition, revenue itself has benefitted from a number of tailwinds that cannot last forever. As a result, operating margins are running close to all-time highs while, at the same time, earnings-per-share have also benefited from massive amounts of stock buybacks, debt refinancings, and lower tax rates. In a nutshell, we should not expect these outsized rates of earnings growth in the future.

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Many of the tailwinds that contributed to earnings growth over the past few years have now turned into headwinds. In the table below, we discuss the many factors that have influenced the rate of earnings growth over the past few years. As you will see, companies (in the aggregate) have a pretty steep hill to climb.

Where has the EPS growth come from?

Affect on earnings going forward
Revenue Federal government defecit
Spending has leveled off, temporarily -
  Low consumer savings rate Savings rate trending higher now -
  Temporary reduction in payroll tax Already reverted back; income tax rate -
  Increase in transfer payment Leveling off -
  Acquisitions Increasing +
  Stock market gains for wealthy Ongoing +
  Exchange rate fluctuations Dollar now increasing in value -
Operating expenses High unemployment Wage pressures increasing a bit reflecting tightening labor market -
  Idle factory capacity Capacity utilization trending up -
  Restructuring (ie layoffs) Layoffs have declined materially, companies operating lean -
  Deferral of investments Companies continue to favor stocks ?
  Acquisition integration M&A activity increase +
Other income Gains on sales of securities Will decrease in an environment of raising rates -
  Gains on divestitures Divestitures and spin-ups such as HP's may increase ?
Interest expense Paydowns of high-cost debt Ongoing, but opportunities waning -
  Refinancing of debt Ongoing, but window may be closing if/when rates rise -
Taxes Change in mix of business to outside US Ongoing, but may subside as global economy slows +
  Stimulus-related tax breaks Corporate tax outlook highly uncertain until after elections ?
Shares outstanding Buybacks Likely to slow due to market appreciation -

We do not think that the benefits of strong corporate earnings growth can continue to accrue overwhelmingly to capital over labor. Although there remains a large amount of slack in the labor market, there will come a day when wage pressures increase. Moreover, wealth and income disparity has become a very hot topic in recent years, and we wouldn't be surprised to see continued efforts by politicians to redistribute the economic benefits of the recovery.

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Corporate profit margins have always reverted back to the mean. They are significantly above average today, and they could certainly continue to head higher from here. Predicting the turns for a metric like this is as futile as predicting the direction of interest rates. Our view, however, is that some reversion to the mean is highly likely over a period of years, and therefore expectations for earnings growth should be tempered going forward.

As such, we remain invested, but we remain defensive. Sticking to quality in times like these can offer continued participation in the upside while protecting capital in the event of a market downturn.

Commentary by Michael K. Farr, president of Farr, Miller & Washington and a CNBC contributor.

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