Third quarter earnings season was a good one, unfortunately we
may not be able to say the same about the fourth quarter. We
got off to a very weak start, and while the last week was better,
it just pushed the season from being very poor to mediocre at
best. So far 183, or 36.6% of the S&P 500 firms have
reported. However, assuming that all the remaining firms
report exactly in line with expectations, then 50.2% of all
earnings are in.
Normally, when all is said and done, the median surprise runs
about 3.00% and the ratio about 3.0. So far, the median is at
1.87% and the ratio is 1.81. 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 this, only to fade towards these
Total net income for the 183 that have reported is 7.08% above a
year ago. That is a big improvement over the negative 3.79% a
week ago when just 70 firms had reported. It is still less
than half the 14.82% growth rate that the same 183 firms reported
in the third quarter. The picture is just a little bit better if we
take the Financials out of the picture. Without them,
the year-over-year rise in net income is 11.84%, down from 16.1%
growth in the third quarter.
The bar is also set low for the remaining 317 firms, and
significantly lower than the results we have seen so far.
They are expected to see year-over-year growth of just 1.93%.
If we exclude the Financial sector, earnings are expected to be
2.02% below last year's. That is far below the 15.99% total
and 19.16% ex-Financial growth those 317 reported in the third
quarter. In other words, we have started out weak, and it is
expected to get worse.
Revenue growth has held up better, with the 183 reporting 6.05%
growth. Most of the revenue weakness though has come from the
financials. If we exclude the Financials that have reported,
revenue is up 9.05% year over year. The 317 are expected to
see revenue growth to slow to 3.08% in total and 7.56% excluding
the Financials. In the third quarter, the 317 reported
revenue growth of 13.16% in total and 14.18% excluding the
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 183, net margins have come in at
11.32%, up from 11.21% a year ago, but down from 11.82% in
the third quarter. For the 317, 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
7.42% from 7.51% last year, and well below the 7.78% in the third
Excluding Financials the picture is even worse, with net margins
of just 6.90% expected, down from 7.57% a year ago and 7.96% 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
9.04% in 2011 and 9.26% 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 8.67% in 2011. However, they are
expected to drop to and 8.62% in 2012.
Full-Year 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 $894.6 billion, or increases of 46.5% and
13.4%, respectively. The expectation is for 2012 to have
total net income come close to $1 Trillion mark to $983.0 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, 6.01%
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
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.
The "EPS" for the S&P 500 is expected to be over the $100
"per share" level for the first time at $103.73 in
2012. That is up from $56.83 for 2009, $83.23 for 2010,
and $94.38 for 2011. In an environment where the 10-year
T-note is yielding 1.90%, 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 Picking Up
Estimate revisions activity is past its seasonal low, and rising
very fast. 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 0.50, or two cuts for every
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, Health Care, and Utilities
are seeing more than twice as many cuts as increases. The
picture for FY2 ( mostly 2012) is only slightly better, with a
revisions ratio of just 0.61. Only three sectors, Transports,
Construction and Business Service 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 0.52 and 0.59, respectively.
Relative to recent quarters, we are off to an exceptionally weak
start, but we are still seeing more positive than negative
surprises. We did get some very big and significant positive
surprises in the last week, most notably
). As the earnings season has progressed, things have been
getting a bit better, but only moved the season from being very
poor, to Mediocre at best. 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 99 S&P 500 firms
scheduled to report. Thus by next week, we will be well past
the halfway point in terms of the number of reports. We are
already past it based on the total earnings for the quarter.
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