Second quarter earnings season is well underway now with 319, or 63.8%, of S&P 500 reports in. With the exception of a handful of financials, most notably Bank of America (BAC), which had a $12 billion negative swing in net income from last year, this is another great earnings season.
The year-over-year growth rate for the S&P 500 is 10.8%, way off the 21.4% pace those same 319 firms posted in the first quarter. However, if you exclude the Financial sector growth is 21.5%, down only slightly from the 23.7% pace of the first quarter.
The 63.8% 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 69.9% 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 very strong start, with 11.29% year-over-year growth for the 319, actually up from the 9.38% growth they posted in the first quarter. The top-line results are even more impressive if the Financials are excluded, rising to 11.78% from the 9.38% pace of the first quarter. Top-line surprises have been almost as good as than the bottom-line surprises, with a median surprise of 2.04% and a 2.83 surprise ratio.
Rate of Growth Slowing
For those (181) 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 4.5%, in total and 11.7% ex-Financials. I suspect that the actual growth will be somewhat higher than is now expected. Putting together the reported results, and assuming that all remaining firms come in exactly as expected, growth will be 8.8% in total, and 17.6% excluding the Financials.
Revenue growth for the remaining firms is also expected to slow, to 3.56% among those yet to report, down from 7.79% they reported in the first quarter. Excluding the Financials, growth is expected to match the 7.90% of the first quarter. That is still very respectable, especially considering that GDP grew only at 1.3% in the Second Quarter with low inflation. Much of the strong revenue growth is coming from the commodity oriented Energy and Materials sectors.
Net Margins Eroding
Net margins have been one of the keys to earnings growth, but cracks in the story are starting to appear. The 319 S&P 500 companies that have reported have net margins of 9.88%, up from 9.93% a year ago. That, however, is due to the Financials, especially BAC. Excluding Financials, next margins have come in at 9.12%, up from 8.40% a year ago.
The higher-margin firms have reported early. The remainder are expected to post net margins of 7.75% up from last year’s 7.68%. Excluding Financials, the expected net margins are 7.76%, up from 7.57% 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 9.31% in 2011 and 10.13% 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 8.81% in 2011 and 9.31% in 2012.
Full-Year Expectations Still Healthy
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 $922.4 billion, or increases of 45.6% and 16.0%, respectively. The expectation is for 2012 to have total net income passing the $1 Trillion mark to $1.062 Trillion, for growth of 15.2%.
That will also put the “EPS” for the S&P 500 over the $100 “per share” level for the first time at $111.17. That is up from $57.20 for 2009, $83.27 for 2010, and $96.56 for 2011. In an environment where the 10-year T-note is yielding 2.94% (2.80% after Friday’s plunge), a P/E of 15.62x based on 2010 and 13.47x based on 2011 earnings looks attractive. The P/E based on 2012 earnings is 11.70x.
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 1.45 (up from 1.32 last week) for 2011 and 1.36 (up from 1.26) 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. Earning are, and are going to remain, the single-most important thing for the stock market. Interest rates are an important, but distant second.
Micro Good, Macro Bad
The way I look at things right now is that we are in a neighborhood were 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 is no police fire or sanitation service and the local schools are dangerous hellholes that no sane parent would ever want to send their kids (more than just an analogy given the budget cuts going on around the country). 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 120 S&P 500 (24.0%) firms have dividend yields higher than the yield on the 10-year T-note, and more than half (277, or 55.4%) yield more than the 5-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.
On the macro side however, growth is very weak. In the second quarter the economy grew at only 1.3%, far below the consensus estimates of 1.7% growth. The real shocker in the report were the downward revisions to past quarters. Most notably, the first quarter was revised down to just 0.4% from 1.9% and the fourth quarter was revised down to 2.3% from 3.1%. We need at least 2% growth to bring down unemployment.
The Debt Ceiling Deal
I am not crazy about the deal, at least from the few details that are available at this point. However, the consequences of not getting a deal are hard to overstate, especially if President Obama does not just invoke the 14th Amendment. The deal seems to be a near-complete victory for the GOP and will result in slower growth, or perhaps even negative growth. There are no revenue increases at all in the first part of the deal, despite revenues being at a near-record post-war low as a percentage of GDP.
The only thing it doesn’t have is the “Balanced Budget Amendment” to the Constitution, which if enacted as passed by the House would make it virtually impossible to ever raise any tax again, and would require the Federal spending as a share of GDP go back to levels not seen since the 1950’s (that is before Medicare was enacted, so Medicare would probably have to be almost entirely eliminated). The proposed amendment would require that the Federal government spend no more than 18% of the prior year’s GDP.
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 also would raise the debt ceiling enough so that we don’t have to go through this circus again in just a few months.
Budget Cuts to Further Economy
The budget cuts that Congress has passed are slowing the recovery, and the massive cuts being demanded will slow the economy further. We only grew at 0.4% in the first quarter. We would have grown at 1.6% except for the spending drag from reduced government spending. The drag in the second quarter was much less, due to a rebound in Defense spending, but we still would have grown 1.5% without the government spending drag.
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 actually help the economy. That has, however, become a religious belief by many, impervious to either logic or evidence (sort of along the lines of the world being created in six days). Both tax increases and spending cuts will tend to slow the economy. How much varies a great deal depending on the details of the tax increases and the spending cuts.
Ultimately, Remain Positive
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 whatever drama DC cooks up next. Valuations on stocks look very compelling, with the S&P trading from just 13.47x 2011, and 11.70x 2012 earnings.
Zacks Investment Research
