The Earnings Picture
Second quarter earnings season is well underway now, with 136 or 27.2% of the S&P 500 reports in. We are off to a great start, with a single major exception: Bank of America (BAC), which had a $12 billion negative swing in net income from last year, due to its settlement of most of its mortgage problems it bought with Countrywide Financial.
That pulled down the overall growth rate for the S&P 500 to just 3.56%, way off the 15.3% pace those same 136 firms posted in the first quarter. However, it you exclude financial sector, growth is 21.8%, actually up from the 19.1% pace of the first quarter.
The 27.2% reported figure actually understates how far we are along in earnings season. If all the remaining firms were to report exactly in line with expectations, we now have 37.8% of the total earnings in. The Tech sector in particular has had many high profile positive surprises, including Apple (AAPL), Google (GOOG) and Intel (INTC).
Top-line results are also off to a very strong start, with 7.01% year-over-year growth for the 136, actually up from the 6.38% growth they posted in the first quarter. The top-line results are even more impressive if the Financials are excluded, rising to 14.003% from the 13.17% pace of the first quarter.
Top-line surprises have been almost as good as than the bottom-line surprises, with a median surprise of 2.01% and a 3.50 surprise ratio. In the early going, though, the medians and surprise ratios can see very sharp fluctuations, so it is still a bit early to read too much into the results.
Rate of Growth to Slow
For the vast majority (364) still to report, the rate of growth is expected to be well below what we have seen already (excluding the BAC effect), with growth of 12.4%, both in total and ex-Financials. I suspect that the actual growth will be somewhat higher than is now expected. Normally about three times as many firms will report positive surprises as disappointments, and that in turn makes the initial growth projections very conservative.
Revenue growth for the remaining firms is also expected to slow, to 6.47% among those yet to report, down from 9.77% they reported in the first quarter. Excluding the Financials, growth is expected to slow to 9.12% from 9.94% in the first quarter. That is still very respectable, especially considering that GDP probably grew only at 1.5% or so in the second quarter with very low inflation. Much of the strong revenue growth is coming from the commodity-oriented Energy and Materials sectors.
Net Margins Curbing a Bit
Net margins have been one of the keys to earnings growth, but we are starting to see some cracks in that story. The 136 that have reported have net margins of 12.05%, down from 12.46% a year ago. That, however, is due to the Financials, especially BAC. Excluding Financials, next margins have come in at 12.73%, up from 11.92% a year ago.
The higher-margin firms have reported early. The remainder are expected to post net margins of 8.14% up from last year’s 7.11%. Excluding Financials, the reported net margins are 8.82%, up from 87.60% last year.
On an annual basis, net margins continue to march northward. In 2008, overall net margins were just 5.88%, rising to 6.40% in 2009. They hit 8.65% in 2010 and are expected to continue climbing to 9.32% in 2011 and 10.05% 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 7.07% in 2009, but have started a robust recovery and rose to 8.27% in 2010. They are expected to rise to 8.88% in 2011 and 9.22% in 2012.
Looking to Full-Year Results
The expectations for the full year are very healthy, with total net income for 2010 rising to $795.4 billion in 2010, up from $544.3 billion in 2009. In 2011, the total net income for the S&P 500 should be $920.0 billion, or increases of 45.6% and 15.7%, respectively. The expectation is for 2012 to have total net income passing the $1 Trillion mark to $1.048 Trillion.
That will also put the “EPS” for the S&P 500 over the $100 “per share” level for the first time at $109.79. That is up from $57.23 for 2009, $83.26 for 2010, and $96.30 for 2011. In an environment where the 10-year T-note is yielding 2.97%, a P/E of 16.14x based on 2010 and 13.95x based on 2011 earnings looks attractive. The P/E based on 2012 earnings is 12.24x.
Estimate Revisions Very Active
Estimate revisions activity is soaring (as is seasonally normal). During the seasonal decline in revisions activity, the ratio of increases to cuts also declined sharply, from over 2.0 at the height of the last earnings season, to slightly below 1.0 for both this year and next. Now as activity is ticking up, so are the revisions ratios standing at 1.32 ( up from 0.98 last week) for 2011 and 1.26 (up from 1.00) for 2012.
The fundamental backing for the market continues to be solid. It is important to keep your eyes on the prize. There is lots of news out there, and much of it is more dramatic than earnings results, but rarely does it have more significance for your portfolio.
Earnings are, and are going to remain, the single most important thing for the stock market. Interest rates are an important, but distant second.
Nice House, but…
The way I look at things right now is that we are in a neighborhood where most of the houses look like they could be on an episode of “Cribs” or the old “Lifestyles of the Rich and Famous.” Unfortunately, there are no police, fire or sanitation services and the local schools are dangerous hellholes. The individual companies all look great with extremely strong balance sheets and rapidly rising net income. The macro-environment, however, is perilous.
Things at the micro level — earnings and valuations — provide plenty of reason to be bullish. This is particularly true when one looks at the prevailing level of interest rates. Currently 94 S&P 500 (18.8%) firms have dividend yields higher than the yield on the 10-year T-note, and more than half (254, or 50.8%) yield more than the five year note.
One thing is absolutely certain: the coupon payment on those notes will never go up, while companies have been raising their dividends at a rapid pace of late. Nearly one quarter of the firms in the S&P 500 have raised their dividend at more than a 10% per year rate over the last five years, and those five years include the worst economic downturn since the 1930’s.
The old Fed model suggests that it is the earnings yield, not the dividend yield, that should be in line with the 10-year note. The earnings yield based on 2011 earnings is 7.17% and on 2012 earnings it is 8.17%.
International Conundrum
In Europe, the debt cancer continues to metastasize. Just after it looked like the Greek problem had been kicked down the road for another year or so (don’t kid yourself into thinking the problem is even close to being solved there, there will eventually be a default or a restructuring in which private sector investors have to take substantial haircuts) all of a sudden Italy moved into the spotlight. Italy is both too big to fail — also too big to bail out, as the third largest economy in the Euro zone — and the fourth largest in the E.U.
We got a bit more can kicking this week, but in the long run one of two things will have to happen, either the Euro will cease to exist, or Europe will have to become far more fiscally integrated, meaning that the individual countries will have to give up most of their sovereignty.
The markets do not seem to have priced in the possibility that it will be the U.S., not any of the PIIGS that is the first to actually default. OK, interest payments will have first call on the existing cash flow the government has, so China and the other holders of U.S. debt will probably get paid, everyone else though should be very worried if the debt ceiling is not raised.
There is a very real possibility that Social Security checks will not go out in August, and doctors will not be paid for Medicare/Medicaid work. I suspect that the paychecks troops in combat would have second call on the current revenues, but the troops stateside might see their paychecks delayed.
There is no official protocol on which of the 80 million checks the government cuts each month will have precedence. In any case, the ratings agencies have all made clear still downgrade our debt even if the Government defaults on its other obligations, even if it continues to make interest and principal payments on the debt.
Countdown to Disaster?
The difference between Greece and the U.S. is that Greece is unable to pay its debts. The U.S. if the debt ceiling is not raised will simply be unwilling to do so. That would be entirely an unforced error.
The Government of the United States defaulting on its debt is likely to have a much larger impact on the markets and the economy than the impact of Lehman Brothers defaulting on its debts. Greece is a rounding error in the world economy relative to the U.S. America would be shoved right back into recession, and one deeper than the one that followed the Lehman collapse. If that happens, then corporate profits would also collapse.
However, when push comes to shove, I find it hard to believe that even Congress could be so stupid as to not raise the debt ceiling. Sort of like I don’t think that nuclear war with China or Russia will ever happen.
Negotiations broke down on Friday afternoon. The chances of this ending tragically grow with each passing day.
The proposed amendment would require that the Federal government spend no more than 18% of the prior year’s GDP, and would make increasing taxes almost impossible, by requiring a two thirds majority in both houses. I would note that the last time that federal spending was less than 18% of the GDP four quarters earlier was in the third quarter of 1965, and has averaged 20.94% since 1948 (and 22.77% since Reagan took office). It will also happen at a time when the Baby Boomers are retiring, and thus will be using Medicare and drawing Social Security benefits.
It would also remove all flexibility the government has to deal with future crises, be they military or financial. It passed in the House, but was voted down in the Senate.
If the debt ceiling is not raised, just go ahead and throw out all the earnings forecasts for both this year and next. The economic devastation will take down nearly every firm’s results. Total net income for the S&P 500 would be hard pressed to get above $500 billion in 2012, not be over $1 Trillion as is currently forecast.
Budget Cuts Slowing Recovery
The budget cuts that the GOP have already forced are slowing the recovery, and the massive cuts they are demanding will slow the economy further. We only grew at 1.9% in the first quarter, which is not fast enough to bring down unemployment.
It looks to me as if the growth rate in the second quarter will be below the first quarter pace, probably around 1.5%. Over the long term we need to close the budget gap, but we need a balanced approach to it. There is zero economic justification for the view that any tax increase slows the economy, and that cuts to spending do no economic harm, or even as some talking heads claim, actually help the economy.
In theory, both tax increases and spending cuts will tend to slow the economy, but by how much varies a great deal depending on the nature of the tax increases and the nature of the spending cuts. I think proposals that have been rejected are out of balance already, but the insistence on 100% spending cuts is simply extreme and will do significant damage to the economy, both short term and long term.
Stay Invested but Buy Insurance
In the end, I find it almost impossible to imagine the debt ceiling not being raised. Is it possible that our elected leaders could be that stupid and quite frankly unpatriotic as to let the U.S. government default, and to do so at a time of near-record-low interest rates. The chance of this “game of chicken” having a tragic ending is no longer trivial. That tragic ending would result in a huge market crash, probably pushing the S&P back down into triple digits.
Taking out some insurance would make a lot of sense here. My preferred way of doing so would be to buy some out of the money September puts. On the SPY (the S&P 500 ETF) the September 120 puts (in the money if the S&P 500 falls below 1200) are only trading for $0.61. Obviously I hope that they would expire worthless, just as I hope that my life insurance policy does not pay off anytime soon. Still, it is insurance that would be well worth having. On the other hand, if we get a debt ceiling agreement, the market will probably rally.
On balance I remain bullish, and I think we will end the year with the S&P 500 north of 1400, but that does not mean we will have a smooth ride between here and there. Strong earnings should trump a dicey international situation, and the drama in DC (provided it turns out to be just drama).
Valuations on stocks look very compelling, with the S&P trading from just 13.95x 2011, and 12.24x 2012 earnings. That is extremely competitive with the 2.97% yield on the 10 year treasury note. However, be prepared to move to the exits (or have some put protection in place) if it looks like the debt ceiling will not be raised. I suspect we are in for a bumpy ride over the next month or so.
Zacks Investment Research
