The Earnings Picture
Third quarter earnings season was a good one, but unfortunately we may not be able to say the same about the fourth quarter. While it is still way too early to draw any firm conclusions, only 29 firms of the S&P 500 (5.2%) have reported, the median surprise is 0.00% and the surprise ratio is just 1.40.
Normally, when all is said and done, the median runs about 3% and the ratio about 3.0. While we don’t have the drama of multi-billion dollar bank losses, this is the weakest start to an earnings season since the depths of the Great Recession. In most recent quarters, we have started out of the gate much faster than that, only to fade toward lower levels.
If we are going to have a “normal season” we will have to see the later reporting firms come in stronger than the early reporters. Total net income for the 29 that have reported is just 1.04% higher than a year ago — a sharp slowdown from the 10.6% growth those same 29 firms reported in the third quarter.
The bar is also set low for the remaining 471 firms. They are expected to see year-over-year growth of just 2.14%, or 2.36% if we exclude the Financial sector. That is far below the 15.0% total and 18.4% ex-Financial growth those 471 reported in the third quarter. In other words, we have started out very weak, and it is not expected to get much better.
Revenue Growth Holding Up
Revenue growth has held up better, with the 29 reporting 7.20% growth, and 7.16 if we exclude the one Financial that has reported (J.P. Morgan {JPM} reported on Friday, in line on earnings but disappointing on revenues, but the cut-off for this data is Thursday night).
The 471 are expected to see revenue growth to slow to 3.31% in total, and 7.62% excluding the Financials. With revenue growth slowing but holding up better than net income growth, it means that the net margin expansion game is coming to an end. It has been a very big part of the spectacular earnings growth that we have seen coming out of the Great Recession.
For the 29 already reported, net margins have come in at 6.34%, down from 6.76% a year ago, and 6.81% in the third quarter. For the 471, margins are expected to be higher, but also fall to 8.98% from 9.08% last year, and well below the 9.52% in the third quarter. Excluding Financials the picture is even worse, with net margins of just 8.47% expected, down from 8.90% a year ago and 9.26% in the third quarter.
Net Margin Expansion Over?
While in an absolute sense, those are still very healthy net margins — much higher than the average of the last 50 years or so — they are no longer expanding. Then again, it was unrealistic to expect that they would always rise. It does mean that earnings growth is going to be harder to come by going forward.
On an annual basis, net margins continue to march northward. In 2008, overall net margins were just 5.88%, rising to 6.27% in 2009. They hit 8.51% in 2010 and are expected to continue climbing to 9.15% in 2011 and 9.33% in 2012. The pattern is a bit different, particularly during the recession, if the Financials are excluded, as margins fell from 7.78% in 2008 to 6.93% in 2009, but have started a robust recovery and rose to 8.12% in 2010. They are expected to rise to 8.71% in 2011. However, they are expected to drop to and 8.66% in 2012.
Total Revenues in Right Direction
Total net income rose to $789.0 billion in 2010, up from $538.6 billion in 2009. The expectations for full year 2011 are very healthy. The total net income for the S&P 500 should be $898.6 billion, or increases of 46.6% and 13.9%, respectively.
The expectation is for 2012 to have total net income come close to $1 Trillion mark to $987.2, for growth of 9.9%. Consider those earnings relative to nominal GDP. If we use the middle of the year GDP level, S&P 500 net income has climbed from 3.89% in 2009 to 5.45% in 2010, and assuming that the 2011 expectations are on target, 6.02% in 2011.
Of course, the S&P 500 earns a lot of its income abroad, and there are a lot more than 500 companies in the U.S. so to some extent that is an apples to oranges comparison. It is somewhat ironic that the growth in earnings was robust when the economy was anemic, but now that the economy seems to be picking up, earnings growth is slowing down dramatically.
Europe, however, is falling back into recession, and even if the Euro does not totally fall apart, its descent is likely to be a deep and nasty one. The BRICs have also all shown signs of slower — but still robust by developed country standards — growth.
A much broader measure of (domestic only) corporate profits tracked by the government rose to 9.92% of GDP in the third quarter. Since 1959 (when the data starts), that measure has averaged 5.99% of GDP. It is still not a record, though — that was set in the third quarter of 2006 at 10.29% of GDP. Meanwhile, wages fell to a record low of just 43.75% of GDP, while the average since 1959 is 48.42% of GDP.
Higher profits are great for the stock market, but ultimately companies need customers, and their customers need to have income (or borrowing capacity). Thus there has to be a very real question about the sustainability of these great earnings. I don’t think it is wise to assume that corporate profits will continue to take an ever larger share of the economic pie.
S&P “EPS” Expected to Top $100 in 2012
The “EPS” for the S&P 500 is expected to be over the $100 “per share” level for the first time at $104.14 in 2012. That is up from $56.79 for 2009, $83.20 for 2010 and $94.77 for 2011. In an environment where the 10-year T-note is yielding 1.85%, a P/E of 15.6x based on 2010 and 13.7x based on 2011 earnings looks attractive. The P/E based on 2012 earnings is just 12.4x.
Estimate revisions activity is past its seasonal low, and should at least triple from here by early to mid-February. We saw a little bit of a bounce in the ratio of upwards to downwards revisions during the third quarter earnings season, especially for this year, but now that bounce seems to be over.
More Cuts Than Increases
Once again, there are more estimate cuts than increases, with a 0.52 ratio. That is almost two estimate cuts for every increase. That is now well into bearish territory. The situation for 2012 is not a lot better. There the ratio never got above 1.0 during the earnings season, and has now also started dropping again, and currently stands at 0.60. That is also a bearish reading.
At the sector level, with still-low overall revisions activity, the sample sizes are still quite thin, which makes them somewhat less significant, but that does not mean that they should be ignored entirely. For both years, the estimate cuts are very widespread. For 2011, there are just three sectors, Transports, Construction and Aerospace that have seen more upwards than downwards revisions.
For 2012 just one sector — Transports — has more increases than cuts, while three have an equal number of increases and cuts. Meanwhile, for 2011 seven sectors, and for 2012 five sectors, have at least two cuts per increase. Autos and Utilities are faring the worst, but on very thin sample sizes.
In Summation
The third quarter was a good one. However, the expectations are very subdued for the fourth quarter, and the hurdle is getting lower. So far, companies are not clearing that low hurdle at anything like the rate they have in the recent past.
Looking ahead to the first quarter, that slowing is expected to continue, with just 3.41% total, and actually falling 3.63% ex-Financial growth expected. Revenue growth in the first quarter is expected to be moderate as well, with total year over year growth of 4.77% and 5.48% excluding the Financials.
While I think long-term valuations are very attractive at these levels, it does not look like the first quarter earnings season will be the catalyst to kick the market into high gear.
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