There are a few possible explanations that describe the why companies continue to beat EPS expectations but increasingly miss revenue expectations. The first is that companies facing weak growth prospects have been more aggressive in cutting expenses. As these companies continue to tighten their belts, whether by layoffs or other initiatives, the savings flow to the bottom line. A second possible explanation is that many companies are being much more aggressive in buying back their own stock.
Given the low level of interest rates, the economics of borrowing to reduce a company's share count have become much more compelling. And a lower share count leads to higher EPS. And finally, the low level of interest rates has allowed many companies to refinance their higher-cost debt. These savings also flow to the bottom line.
In general, investors should always prefer earnings that are generated through top-line growth as compared to earnings that result from internal corporate actions. There is a limit to the amount of expenses that can be cut and the amount of stock that can be repurchased. In other words, earnings growth that results from cost-cutting and/or stock buybacks is not sustainable. There will be a point at which management cannot get more blood from the stone.
So far, investors appear willing to pay for the earnings growth we see. The hope is that all the Fed's monetary easing will ultimately prime the pump to the point where acceptable revenue growth is again possible. But here's catch-22: Strong corporate revenue growth will only happen if and when we see an improvement in demand for products and services. The only way we will see improvement in demand is through better job and income growth. The only way job and income growth will improve is if companies gain the confidence to invest more aggressively in new projects and employees. Yet companies don't want to invest unless they see the end demand.
There are several possible reasons for the continued strength in stocks. The most plausible explanation, in our view, is that the Fed continues to hold down interest rates and push investors into riskier assets. Stocks, especially high quality ones, appear relatively attractive versus bonds that offer "return-free risk." However, the next leg up for stocks may only come if we see better prospects for top-line growth. Earnings simply cannot keep growing at an acceptable pace unless revenue growth improves.