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The Earnings Picture

Third quarter earnings season was a good one, unfortunately we may not be able to say the same about the fourth quarter. While it is still too early to draw any firm conclusions -- only 70 firms of the S&P 500 (14.0%) have reported -- the median surprise is 1.80% and the surprise ratio is just 1.86. However, assuming that all the remaining firms report exactly in line with expectations, then 22.7% of all earnings are in. 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 towards those weaker 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 70 that have reported is actually 3.79% below what those same 70 firms earned a year ago, and is 9.39% below what they earned in the third quarter. They reported year-over-year growth of 10.02% in the third quarter. The picture is just a little bit better if we take the Financials out of the picture. In the early going, they are a big part of the picture, representing 31.4% of the firms and 37.3% of the total earnings reported.  Without them, the year-over-year decline in net income is just 0.90% and earnings are up sequentially by 2.15%.

The bar is also set low for the remaining 430 firms, but still better than the results we have seen so far. They are expected to see year-over-year growth of just 3.87%, or 2.00% if we exclude the Financial sector. That is far below the 16.89% total and 19.60% ex-Financial growth those 430 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 Better

Revenue growth has held up better, with the 70 reporting 1.98% growth. Most of the revenue weakness, though, has come from the Financials. If we exclude the Financials that have reported, revenue is up 7.42% year over year. The 430 are expected to see revenue growth to slow to 4.65% in total, and 8.20% excluding the Financials. In the third quarter, the 430 reported revenue growth of 12.53% in total and 13.41% excluding the financials.

Net Margin Expansion Ending

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 70, net margins have come in at 12.05%, down from 12.78% a year ago, and 13.13% in the third quarter.  

For the 430, margins are expected to be much lower, but they are lower-margin businesses to begin with. They, however, are also expected to fall, dropping to 8.12% from 8.18% last year, and well below the 8.61% in the third quarter. Excluding Financials, the picture is even worse, with net margins of just 7.77% expected, down from 8.24% a year ago and 8.78% in the third quarter.

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, but we are beginning to see cracks there as well. 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 9.06% in 2011 and 9.31% 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 8.68% in 2011. However, they are expected to drop to 8.65% in 2012.

Net Income Expectations Healthy

Total net income in 2010 rose to $789.0 billion in 2010, up from $538.6 billion in 2009. The expectations for the full year are very healthy. In 2011, the total net income for the S&P 500 should be $893.3 billion, or increases of 46.5% and 13.2%, respectively. The expectation is for 2012 to have total net income come close to $1 trillion mark to $983.8 billion, for growth of 10.1%.

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, 5.99% 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, it is likely to be a deep and nasty crevasse. The BRICs have also all shown signs of slowing -- 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.

Breaking Down the S&P 500 “EPS”

The “EPS” for the S&P 500 is expected to be over the $100 “per share” level for the first time at $103.75 in 2012. That is up from $56.81 for 2009, $83.20 for 2010, and $94.23 for 2011. In an environment where the 10-year T-note is yielding 2.03%, a P/E of 15.8x based on 2010 and 14.0x based on 2011 earnings looks attractive. The P/E based on 2012 earnings is just 12.7x.

Estimate Revisions to Pick Up

Estimate revisions activity is past its seasonal low, and should at least triple from here by early to mid-February. In previous earnings seasons, we have generally seen a bounce in the revisions ratio, as the analysts have reacted to better-than-expected earnings and the outlooks on the conference calls. So far, there is no evidence of that happening.

The revisions ratio for FY1, which is mostly 2011 earnings, now stands at 0.49, or more than two cuts for every increase. The cuts are very widespread, with only a single sector – Transports -- seeing more increases than cuts. Eight of the sectors, including big ones like Energy and Tech, are seeing more than twice as many cuts as increases.

The picture for FY2, or mostly 2012 is only slightly better, with a revisions ratio of just 0.59. Only three sectors -- Transports, Industrials and Construction -- are seeing more increases than cuts. The widespread cuts are also confirmed by the ratio of firms with rising mean estimates to falling mean estimates, which now stand at 0.57 and 0.60, respectively.

Relative to recent quarters, we are off to an exceptionally weak start, but we are still seeing more positive than negative surprises. This is happening when the bar is set at its lowest point in a very long time. For the remaining firms, the bar is also set low, however given the results so far, that really does not provide any assurance that they will be able to clear it.  

The market has been off to a very strong start of the year, despite the weak early results. Valuations are still compelling, if somewhat less so than a few months ago. However, if the results do not improve, it strikes me as likely that we will at least pause for a while. The upcoming week will be a busy one, with 117 S&P 500 firms scheduled to report. Thus by next week, we will be almost at the halfway point, and will be in a better position to “call the election.”

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