Stick a fork in fourth quarter earnings season — it’s done. We now have 496 or 99.2% of the S&P 500 reports in. However, the early reporting firms tend to be a bit bigger and more profitable than the stragglers, and those 496 firms actually represent 99.9% of the total expected net income.
That, of course, presupposes that the remaining firms report exactly as expected, which is unlikely. But at this point, even if they were to disappoint badly, it would really not change the overall picture at this point.
The earnings season has been a strong one, with total net income for those firms rising 30.7% over a year ago. The median surprise of 3.64% is also fairly strong, although the ratio of positive-to-negative surprises is only somewhat above normal at 3.07. The total net income growth of the reporting firms is an acceleration from the 25.0% year-over-year growth those same firms posted in the third quarter.
A Surprisingly Good Quarter
The median surprise understates just how surprisingly good the earnings season was. Before it started, total net income growth was expected to be less than 20%. A big part of the earnings story for the quarter was Financial firms setting aside much less than a year ago for bad debts. If the Financial sector is excluded, total net income rose 19.9% from a year ago, which is not bad either.
Tougher Comps Ahead
Earnings growth is expected to slow significantly in the first quarter to just 8.7%, in large part due to a tougher comparison a year ago. Given the trend of positive earnings surprises, I would be shocked if the actual growth rate is that low. It is almost certain to be in the double digits again.
Revenue growth was healthy at 8.24%, up from the 8.13% growth those 496 firms reported in the third quarter. Looking ahead to the first quarter, though, those firms are expected to post year-over-year revenue growth of just 1.84%. If the Financials are excluded, reported revenue growth is 8.77%, up from 8.34% in the third quarter, and slowing to 2.16% in the first quarter. Tougher year-over-year comparisons are a big part of the story.
Net Margins Excel Again
Thus, the stellar earnings growth is mostly due to the continued expansion of net margins. Much of the year-over-year margin expansion is due to the Financials, where the whole concept of revenues is a bit different from most companies, and thus the concept of net margins is also a bit different.
Much of the earnings growth in the Financials has come from firms setting aside less for bad debts than they did last year. One should be a bit on the doubtful side about the quality of those earnings, particularly in the absence of mark-to-market accounting. Net margins for the quarter were 8.98%, or 8.33% if one excludes the Financials, up from 7.29% (7.38% excluding Financials) a year ago, but down from 9.06% (up from 8.23% excluding Financials) in the third quarter.
On an annual basis, net margins continue to march northward on a yearly basis. In 2008, overall net margins were just 5.88%, rising to 6.39% in 2009. They hit 8.58% in 2010 and are expected to continue climbing to 9.57% in 2011 and 10.25% 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 7.09% in 2009, but have started a robust recovery and risen to 8.23% in 2010. They are expected to rise to 8.80% in 2011 and 9.31% in 2012.
The expectations for the full year are very healthy, with total net income for 2010 rising to $791.3 billion in 2010, up from $545.3 billion in 2009. In 2011, the total net income for the S&P 500 should be $906.5 billion, or increases of 44.7% and 13.8%, respectively.
The early expectation is for 2012 to have total net income passing the $1 Trillion mark to $1.0282 Trillion. That will also put the “EPS” for the S&P 500 over the $100 “per share” level for the first time at $108.38. That is up from $57.48 for 2009, $83.39 for 2010, and $95.58 for 2011. In an environment where the 10-year T-note is yielding 3.36%, a P/E of 15.5 based on 2010 and 13.6x based on 2011 earnings looks attractive. The P/E based on 2012 earnings is 11.9x.
Analysts Raising Projections
With more than three 2011 estimates being raised for every two being cut (revisions ratio of 1.51), one has to feel confident that the current expectations for 2011 will be hit, and more likely exceeded. Analysts are raising their 2012 projections at an even higher rate, with a revisions ratio of 1.62. While a lot can happen between now and the time the 2012 earnings are all in, upward estimate momentum means that the current 2012 earnings are more likely to be exceeded than for them to fall short.
This provides a strong fundamental backing for the market to continue to move higher. The bullish argument is further boosted by such historical factors such as being in the third year of the presidential cycle (almost always the best of the four) and having a Democrat in the White House. Just having a Democrat in the White House has historically meant good things for the stock market, with an average annualized return over the last 50 years more than triple that when the GOP holds the Oval Office. Few, if any, binomial variables have as much statistical significance.
Not All Smooth Sailing
That does not mean that all is smooth sailing ahead. We managed to avoid a government shutdown, but the reprieve only lasts until the end of this week. A government shutdown would not be good for either the market or the economy.
The economy does seem to have made a slow turn towards recovery. Even if we avoid a government shutdown, the House spending cuts of $61 billion would exert a very significant drag on the economy, as will the cuts that are happening on the State and Local levels. Mark Zandi, of Moody’s Economics, and a top economic advisor to the McCain campaign, has estimated that the spending cuts could result in as many as 700,000 fewer jobs being created in 2011 and 2012, combined.
The impact will probably be about 1% slower GDP growth than if the cuts had not happened. The lower growth will result in lower tax collections, so the impact on the budget deficit will be much less than the $60 billion advertised.
Job creation remains sluggish, but is starting to show signs of picking up. We created 222,000 jobs in the private sector in February, up from just 68,000 in January. However, State and Local governments laid off a total of 30,000 people for the month. Those jobs count just like private sector jobs, and are a major headwind to bringing down the total number of unemployed.
The household survey has been much more upbeat, showing growth of 250,000 jobs in February. The unemployment rate fell to 8.9%, and it was as high as 9.8% as recently as November. The drop in December and January was the largest two-month drop in the unemployment rate since 1958, and many thought it was a fluke, but the continued fall in February is an indication that it was for real.
Higher Productivity
Most of the real growth in the economy has come from higher productivity, not more hours being worked. Those productivity gains are accruing to capital: higher profits, not labor (flat wages, slow hiring).
In the fourth quarter, productivity rose at 2.6% while unit labor costs dropped 0.6%. This is a major reason behind the rising net margins, and resulting strong earnings growth. Companies have been able so far to absorb higher commodity prices, and not pass them along to consumers (year-over-year core CPI is just 1.0%) due to those productivity gains. If earnings growth does weaken, I suspect it will be from a slower rise in net margins than currently expected, but there is no evidence of any margin slowdown so far.
Rising commodity prices, most importantly rising oil prices, have the potential to stop the margin expansion, but so far show little sign of actually doing so. Remember that net margins are after taxes, which makes businesses complaints about corporate taxes being too high ring a bit hollow. Federal Corporate taxes are at record lows as a share of GDP (1.29%), less than half what they have averaged since 1947 (3.06%).
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