By Jim Kelleher :
So far in July, calendar 2Q13 earnings are beating analyst and investor forecasts. But to do so, they've required a huge surge in financial earnings. On an ex-financials basis, reporting companies have had to hop over speed bump-like expectations, set abnormally low by corporate guidance. Should the remainder of the quarter proceed like the quarter to date, the first half of 2013 will represent one of the first extended periods in the four-year-old-plus rally in which quarterly stock market appreciation is running well ahead of the annual change in quarterly EPS. That is a trend that bears watching, particularly if earnings acceleration anticipated by Argus does not materialize in the second half.
The 2Q13 quarter to date
On a Street-wide basis, analyst expectations heading into the quarter were typically unstable and all over the map. According to Argus Chief Investment Strategist Peter Canelo, a few weeks ago the analyst consensus was guiding for approximate 2.5% growth in 2Q13 earnings. That number was briefly revised down to the 1.5% range, but had notched back up above 2.5% on the perception that economic conditions were improving.
We base our assessment of the annual change in continuing operations EPS for calendar 2Q13 on date supplied by Bloomberg. Based on 277 out of 500 companies reporting and according to Bloomberg data, the weighted change in 2Q13 earnings on a year-over-year basis so far is 6.9% on a share-weighted basis. The share-weighted change mainly reflects 35%-plus growth in financial companies. Many of the financial giants that have reported to date have released previously taken bad-debt reserves, artificially lifting their results.
Backing out the financial companies that dominate early reporting, the annual percentage change in earnings is barely above break-even. Most of the growth in 2Q13 earnings is coming from Financials, Discretionary, Healthcare, Staples, and Energy. Remaining sectors are posting slightly negative earnings in aggregate.
According to Bloomberg, 73% of reporting S&P 500 companies have beaten analyst expectations for earnings, and 56% have exceeded revenue expectations. We are rarely surprised when companies deliver a positive "surprise" against their carefully stage-managed official guidance.
We expect single-digit growth - perhaps not 6.9%, but around 5% - to hold up for 2Q13 earnings in total. If sustained across the remainder of the 2Q reporting season, this level of growth would represent acceleration from the 2.7% share-weighted annual EPS change that Bloomberg reported for 1Q13.
Sector Splits: Domestic Strength, Global Funk
The leading sectors in the EPS season to date include Financials (up 35%), followed by low double-digit earnings gains for Consumer Discretionary and Healthcare. Notable is that fastest-growing sectors year to date have a decidedly domestic flavor.
The Consumer Discretionary business includes Automotive, Housing, Restaurants & Lodging, and Media - all with a very U.S.-centric revenue base. The big banks dominating early Financial Sector reporting make most of their money at home. So too do most healthcare companies levered to delivery of healthcare services; the big pharma names, global in nature, are an exception.
The sectors with the most anemic growth include Technology, Industrials, Energy, and Materials - all with EPS down in single digits so far in 2Q13. What these sectors have in common is significant overseas exposure. The pending QE taper, along with narrowing deficits, is contributing to dollar strength. Dollar strength negatively impacts commodities priced in dollars, which is pretty much all of them.
Dollar strength may not be the worst depressant, however. China's leaders continue to draw GDP lines in the sand, and then cross them. The latest is that China won't tolerate GDP below 7%; a few weeks before, GDP was not to go below 7.5%, per the Party's orders. "Abe"-nomics in Japan has crushed the yen, making Japan much more globally competitive - and causing fits in Korea and China.
Profits & Stock Trends: Well Aligned Across the Bull Run
Argus came into reporting season modeling above-consensus 5% year-over-year growth for the calendar second quarter. There is some fluidity in that model, based on the accelerating dollar trend and deteriorating emerging-markets trend, and the final outcome may be slightly lower.
But neither are we drinking the consensus Kool-Aid of 2% growth. We are always aware of the fudge factor that corporate CFOs build into their outlooks, knowing that an honest appraisal of prospects will get your stock slammed on reporting day. Our mid-single-digit forecast is higher than the Street, given our assessment of the economic environment and the fact that the Street has persistently underestimated EPS growth rates all through this bull market including in recent quarters.
Yet even if the Street hits our 2Q13 EPS growth target, 4%-6% growth warrants a pretty limp cheer. If the quarter plays out as we expect, it will beat the first-quarter growth rate; but that is not saying much. First-half S&P 500 earnings from continuing operations, according to our estimates, will total around $52.97 and, compared with $51 in the 2012 first half, will have advanced 3.9%.
In the year to date, total return on the S&P 500 has been about 20%. Small caps have been somewhat stronger; but even the Blue Chip DJIA has total return in the high teens. In short, equity total return in 2013 year to date is running at 4- to 5-times the rate of EPS growth.
How has EPS growth lined up with stock-market performance during this bull market prior to 2013? The alignment is not perfect, but it is definitely a better match, at least on an aggregate basis. In 2009, stocks raced out more than 24% in an anticipatory move, while EPS rose just 14%. In 2010, earnings surged more than 45%, but stocks - hit by the Gulf Gusher and dislocations over public programs (first-time homebuyers credit, cash for clunkers) rose a respectable but lagging 12.8%. In 2011, EPS grew a further 18%, but stock markets were dead flat after the near-bear market around the debt ceiling deadline.
The year 2012 showed the first signs of stock gains racing out ahead of EPS fundamentals. The S&P 500 rose 13.4% in 2013 while earnings rose only 4%. But after all those strong EPS growth years, valuations had some slack to play with; and we were willing to countenance a catch-up year. All in, from a low of $49.49 in 2008 to $102 in 2012, earnings rose 106%. Meanwhile, from a low of 676 in March 2009 to a 2012 closing price of 1,426, the S&P 500 rose a total 111%. As noted, that is good alignment in aggregate, even with the deterioration in 2012 profit growth.
Seeking Growth to Justify Stock Moves
We have continued to express our enthusiasm for domestic equities even amid the frankly soft EPS growth trend of the past four-to-six quarters. Yes, U.S. stocks are emerging as the "cleanest dirty shirt in the closet," as emerging markets succumb to currency gyrations, and as bond markets respond to the end of QE-induced repression in interest rates. But we are not be making a case for equities on relative performance alone.
We are currently modeling much stronger EPS growth trends in the back half of 2013. Specifically, we are modeling $57.83 in 2H13 EPS rising 13.4% from $51 in 2H12. On an individual quarter basis, we look for 11% growth in 3Q13, followed by 15% growth in 4Q13. All our numbers are subject to change, particularly in what is soon to be the aftermath of 2Q EPS season. But we still anticipate being fairly aggressive on forecast earnings even after all 1H13 adjustments have been made.
Market memory is astonishingly short. "Fiscal cliff," on everyone's lips nine months ago, is now a footnote in a dusty volume. But the caution then around the far-from-certain outcome to the Presidential Election, the fiscal cliff, and on-rushing sequestration all caused a slowdown in domestic activity. Investment and business spending, already suffering from uncertainty in 3Q12, began to freeze early in 4Q12 and was approaching paralysis by December. Note that S&P 500 continuing operations earnings in second-half 2012 were $51, which was flat with the first-half level
While comparisons will get easier in 2H13 and particularly in 4Q13, improving economic activity counts as the more important growth driver. We have lately seen a slew of uninspiring economic reports; this is consistent with usual summer sluggishness. While month-over-month change in housing, industrial production, factory orders and the like are weak to negative, pay attention to the annual rate of change, which in many categories remains in double-digits.
Earnings growth is required to sustain the stock market; and without earnings growth, a rising market is riding for a fall. We are always calling out this or that data point, index price point, or geo-political event as being paramount. But what ultimately matters is that earnings must grow strongly in 2H13, or the bull market case will be seriously eroded, if not suspect.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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