Still More Upward Revisions

Key Points:

First quarter season is effectively over. So far 495 (99.0%) of S&P 500 reports in. Median surprise of 3.70% and surprise ratio of 3.01 for EPS, 1.32% and 2.23 for revenues. Solid growth of 17.1% (19.2% ex-Financials) reported. Slowdown from fourth quarter pace of 30.9%, mostly due to super financial growth in 4Q. Growth ex-Financials as 19.8% in 4Q among the 495 that have reported.
Quarterly net margins reported rise to 9.38% from 8.70% a year ago, up from 8.93% in fourth quarter. Margins excluding Financials rise to 8.22% from 7.53% last year, 8.05% in fourth quarter. In the second quarter 9.63% net margins expected, 8.56% ex-Financials.
Full-year total earnings for the S&P 500 jumps 45.5% in 2010, expected to rise 14.8% further in 2011. Growth to continue in 2012 with total net income expected to rise 14.6%. Financials a major earnings driver in 2010. Excluding Financials, growth was 27.4% in 2010, and expected to be 15.0% in 2011 and 13.2% in 2012.
Total revenues for the S&P 500 rise 8.24% in 2010, expected to be up 5.30% in 2011 and 6.20% in 2012. Excluding Financials, revenues up 9.71% in 2010, expected to rise 8.94% in 2011 and 6.03% in 2012.
Annual Net Margins marching higher, from 5.88% in 2008 to 6.39% in 2009 to 8.59% for 2010, 9.35% expected for 2011 and 10.11% in 2012.
Margin Expansion major source of earnings growth. Net margins ex-Financials 7.79% in 2008, 7.08% in 2009, 8.22% for 2010, 8.67% expected in 2011 and 9.26% in 2012.
Revisions ratio for full S&P 500 at 1.42 for 2011, at 2.67 for 2012, both bullish readings. Ratio of firms with rising to falling mean estimates at 1.59 for 2011, 1.84 for 2012, also very positive readings. Total revisions activity plunging.
S&P 500 earned $545.6 billion in 2009, rising to $792.3 billion in 2010, expected to climb to $909.9 billion in 2011. In 2012, the S&P 500 are collectively expected to earn $1.043 Trillion.
S&P 500 earned $57.13 in 2009: $83.15 in 2010 and $95.49 in 2011 expected bottom up. For 2012, $109.41 expected. Puts P/Es at 15.8x for 2010, and 13.8x for 2011 and 12.0x for 2012 -- very attractive relative to 10-year T-note rate of 3.18%. Top down estimates, $95.87 for 2011 and $103.94 for 2012.

Still the Estimates Rise

The first quarter earnings season is almost done. We now have 496 (99.0%) of the S&P 500 reports in. Net income growth is 17.12%. While that is down from the extremely strong 30.9% that 495 of those firms posted in the fourth quarter, it is still a very strong growth rate. Almost all of the growth slowdown is from a failure of the Financial sector to repeat the massive growth they posted in the fourth quarter.

It’s not that the Financials are having a bad quarter, but they do face much tougher comps this time around. The 8.7% year-over-year growth they are reporting is not exactly awful (although it is below the rest of the S&P 500), it is that it pales in comparison to the 161.8% growth posted in the fourth quarter. That is despite a very strong sequential growth of 22.0%.

If we back out the Financials, total net income is up 19.2%, down just slightly from the 19.8% those firms reported in the fourth quarter. Looking ahead to the second quarter, growth is expected to continue to slow, falling 10.1%. Back out the Financials and growth is expected to be 12.6%.

Before the first quarter earnings season started, it was expected that growth would be just 6.7% for the S&P 500 as a whole, and 10.2% excluding Financials. Given the upward estimate momentum (more below) it seems highly likely to me that the actual growth in the second quarter will be significantly higher than the 10.1%/ 12.6% now expected.

Revenue Growth Strong

Revenue growth is also very strong at 8.56%, up from the 8.31% growth they posted in the fourth quarter. Financials are a major drag on revenue growth, if they are excluded, reported revenue growth is 10.49%, up from the 8.35% growth posted last quarter. Revenue growth is also expected to slow in the second quarter, falling to 4.96% year over year for the S&P 500 as a whole. Revenue growth is expected to slip to 8.75% if the Financials are excluded.

Relative to the expectations before the quarter started, the revenue outperformance has been just as spectacular as the earnings performance. Before the earnings season started, growth expectations were just 1.41% overall, and 2.16% if the Financials are excluded.

Net Margin Expansion

Net margin expansion has been a driver of earnings growth, but that expansion is slowing down, particularly if one excludes the Financials. Overall net margins are 9.38%, up sharply from 8.70% a year ago and from 8.93% in the fourth quarter.

Strip away the Financials and the picture is somewhat different, rising to 8.22% from 7.55% a year ago and from the 8.05% reported in the fourth quarter. At the start of the season, net margins were expected to be 9.13%, and 8.14% excluding the Financials.

Cyclicals Lead the Way

The more cyclical parts of the economy are leading the growth charge this quarter. The highest growth comes from the Industrials sector, with growth of 66.0%. Three other sectors are posting growth over 40%, Materials (48.3%), Autos (46.9%) and Energy (40.6%).

Construction was by far the weakest sector, with net income plunging 34.3%. Utilities were the only other negative growth sector, with earnings falling 1.1%. Anemic -- but positive -- growth of 3.8% was posted for Staples.

On an annual basis, net margins continue to march northward. In 2008, overall net margins were just 5.88%, rising to 6.39% in 2009. They hit 8.59% in 2010 and are expected to continue climbing to 9.35% in 2011 and 10.11% 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 7.08% in 2009, but have started a robust recovery and rose to 8.22% in 2010. They are expected to rise to 8.67% in 2011 and 9.26% in 2012.

Full Year Expectations Still Healthy

The expectations for the full year are very healthy, with total net income for 2010 rising to $792.3 billion in 2010, up from $545.6 billion in 2009. In 2011, the total net income for the S&P 500 should be $909.9 billion, or increases of 45.5% and 14.8%, respectively. The expectation is for 2012 to have total net income passing the $1 Trillion mark to $1.043 Trillion.

That will also put the “EPS” for the S&P 500 over the $100 “per share” level for the first time at $109.41. That is up from $57.13 for 2009, $83.15 for 2010 and $95.49 for 2011. In an environment where the 10-year T-note is yielding 3.03%, a P/E of 15.8x based on 2010 and 13.8x based on 2011 earnings looks attractive. The P/E based on 2012 earnings is 12.0x.

The analysts have responded to the better-than-expected earnings for the first quarter by raising their estimates for 2011. That’s not particularly shocking, as the first quarter is, after all, part of 2011, so if they did not increase in response to a positive surprise, they would implicitly be cutting their estimates for the remaining three quarters of the year.

Impressive Estimate Increases

Still, the flood of estimate increases is impressive, with the revisions ratio sitting at 1.42. Total estimate revisions activity is now well passed its seasonal peak. Thus, over the next month or so, changes in the revisions ratio will be driven more by old estimates falling out of the four-week moving totals than by new estimate changes being made. The estimate increases are widespread, with the ratio of firms with rising mean estimates to firms with falling estimates standing at 1.59.

There is no “mechanical” reason for the estimates for 2012 to be rising; those are even stronger than the ones for 2011. The 2012 revisions ratio is now at 1.67, meaning that upwards estimate revisions are out pacing cuts by more than 5:3 for next year. The ratio of companies with rising to falling mean estimates stands at 1.84. Those are extremely bullish readings.

Market to Continue Moving Higher

This provides a strong fundamental backing for the market to continue to move higher. 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.

...But Expect Some Turbulence

That does not mean that all is smooth sailing ahead. In a similar, but contrary nod to history, we are now at the softest part of the year (historically). There is a fair amount of truth to the old adage “Sell in May, but remember to return by November.” Since 1945, the gain on the S&P 500 has averaged 6.8% (ex-dividends) from November through April, but only 1.3% from May through October.

The biggest threat to the market is if the debt ceiling is not raised by the beginning of August. If it looks like it will not happen; watch out. The Government of the United States defaulting on its debt is likely to have a somewhat larger impact on the markets and the economy than the impact of Lehman Brothers defaulting on its debts.

The nation 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 Congress would let that happen.

While not the most likely case, the chance of no increase by the time the ceiling is hit is a very real possibility. Given the disastrous potential consequences, taking out some insurance in the form of deep out of the money puts would make a lot of sense at this point.

We are already feeling the impact from lower government spending. First quarter GDP growth came in at just 1.8%, down from 3.1% in the fourth quarter. Total government spending was a drag of 1.09 points, up from being a 0.34 point drag in the fourth quarter.

In other words, 0.75 of the total 1.30 point growth slowdown (57.8%) was due to increased austerity in Government spending. The recovery is clearly slowing, but so far, that has not shown up in the analysts profit forecasts.

Unemployment vs. Inflation

The unemployment rate bounced back up to 9.1% in May. Job growth slowed dramatically to just 54,000 in May from 232,000 in April. Overall job growth has been slowed by the loss of government jobs especially at the local level as stimulus funds dry up. Local governments laid off 28,000 in May alone and have handed out 267,000 pink slips over the last year.

Given that the unemployment rate has been higher than that in just 515% of the months since 1950, (more than half of which were during the Great Recession) one might expect that bringing down unemployment would be top of the agenda at both the Fed and on Capitol Hill. However, at Bernanke’s recent press conference, the focus was mostly on inflation.

The rate of headline inflation has been moving higher, but it is only up 3.2% over the last year. That is lower than what we have experienced for most of the last 40 years. Furthermore, commodity prices have just fallen sharply, so we might start to see some relief very soon. Core inflation remains very low, up just 1.3% over the last year.

This fear of phantom inflation is keeping further monetary easing off the table for bringing down unemployment. Because of the deficit, fiscal policy is also off the table. And despite tax revenue as a share of GDP being near a 60-year low, the growth slowdown due to the austerity campaign is likely to reduce tax revenues, and thus the budget-cutting will be very ineffective in it’s supposed goal of bringing down the budget deficit.

International Situation

The international situation clearly has the potential to abort the recovery as well. The disaster in Japan will clearly slow its economy dramatically in the second quarter, although much of that growth will be made up later in the year as the reconstruction process gets under way.

Many U.S.-made products have parts which are made in Japan and that is likely to disrupt production here. Factory output fell 0.4%, the first decline after 9 months of increases largely due to auto plants shut down for the lack of parts.

The debt crisis in Europe is not going away with Portugal now also getting bailed out, even as the ECB makes life tougher on the PIIGS by raising rates. Rates for the Greek, Irish and Portuguese debt are substantially higher than when the crisis first started. It is clear now that at least Greece will be forced to restructure (aka partially default) its debt. The austerity campaigns have weakened those economies and undermined tax revenues, and so the bailouts have not made the situation much better.

Still Bullish Overall

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 are trumping a dicey international situation, and the drama in DC. 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.

Scorecard & Earnings Surprise

First quarter season almost done. 495 (99.0%) of reports in. Results strong, with year-over-year growth of 17.12%, a 3.01 surprise ratio, and 3.70% median surprise. 67.5% of all firms beat expectations.
Positive year-over-year growth for 359, falling EPS for 134 firms, 2.68 ratio, 72.5% of all firms reporting have higher EPS than last year.
Construction only sector with more disappointments than positive surprises.
Expected growth for 1Q at start of earnings season just 6.74%, 10.18% ex-Financials.
Autos, Industrials, Discretionary, Conglomerates and Energy all have median surprises over 6.5%.
Note that the sectors with high positive surprises also have best revisions.

Historically, a “normal earnings season” will have a surprise ratio of about 3:1 and a median surprise of about 3.0%. Thus this quarter is about average. Pay attention to the percent reporting in evaluating the significance of the sector numbers.

Scorecard & Earnings Surprise 4Q Reported
Income Surprises	Yr/Yr Growth	% Reported	Surprise Median	EPS Surp Pos	EPS Surp Neg	# Grow Pos	# Grow Neg
Industrial Products	65.96%	95.45%	8.18	17	4	17	4
Auto	46.88%	100.00%	8.16	6	1	7	0
Consumer Discretionary	15.66%	96.77%	6.60	22	4	22	8
Conglomerates	29.30%	100.00%	6.60	7	2	8	1
Oils and Energy	40.59%	100.00%	6.51	26	13	24	16
Basic Materials	48.26%	100.00%	5.62	21	2	22	1
Finance	8.74%	100.00%	5.31	54	19	58	22
Computer and Tech	24.84%	100.00%	4.35	48	16	52	18
Medical	5.90%	100.00%	4.02	38	5	37	8
Retail/Wholesale	5.58%	97.92%	2.94	33	7	35	12
Aerospace	5.04%	100.00%	2.65	6	2	6	3
Business Service	12.25%	100.00%	2.41	10	4	13	5
Utilities	-1.09%	100.00%	1.01	22	13	24	17
Consumer Staples	3.77%	94.44%	0.48	17	10	22	11
Transportation	23.82%	100.00%	0.00	4	3	8	1
Construction	-34.25%	100.00%	-4.17	3	6	4	7
S&P 500	17.12%	99.00%	3.70	334	111	359	134

Sales Surprises

Strong revenue growth of 8.56% among the 495 that have reported, median surprise 1.32%, surprise ratio of 2.23, 68.5% of all firms reporting better than expected revenues. In 4Q, sales surprise ratio at 1.88, median surprise 0.96%, a strong showing, 64.8% of all firms did better than expected on top line.
Growing Revenues outnumber falling revenues by ratio of 2.88, 73.9% have higher sales than last year, in the 4Q, ratio of 3.46, 77.4% of firms had higher revenues than a year ago.
Autos, Conglomerates, Industrials and Materials lead in sales surprise. Energy and Discretionary also posting better-than-expected top lines. Aerospace and Utilities disappoint.
Expected revenue growth at start of the season was just 1.41%, 2.16% exclusing the Financials.

Sales Surprises
Sales Surprises	Yr/Yr Growth	% Reported	Surprise Median	Sales Surp Pos	Sales Surp Neg	# Grow Pos	# Grow Neg
Auto	13.96%	100.00%	7.357	7	0	7	0
Conglomerates	7.40%	100.00%	3.769	6	2	7	2
Industrial Products	25.26%	95.45%	3.142	18	3	20	1
Basic Materials	19.48%	100.00%	3.005	17	6	22	1
Oils and Energy	25.09%	100.00%	2.408	24	16	30	10
Consumer Discretionary	10.40%	96.77%	2.117	24	6	28	2
Transportation	11.75%	100.00%	1.974	8	1	9	0
Construction	0.84%	100.00%	1.678	8	3	9	2
Medical	2.56%	100.00%	1.453	35	10	39	6
Finance	-2.19%	100.00%	1.239	52	25	40	40
Computer and Tech	15.74%	100.00%	1.191	51	20	55	16
Retail/Wholesale	5.60%	97.92%	1.105	33	14	36	11
Business Service	7.52%	100.00%	0.768	13	5	16	2
Consumer Staples	5.80%	94.44%	0.523	22	12	22	11
Aerospace	-3.24%	100.00%	-1.333	4	5	8	1
Utilities	-0.69%	100.00%	-1.631	17	24	18	22
S&P 500	8.56%	99.00%	1.319	339	152	366	127

Reported Quarterly Growth: Total Net Income

The total net income is 17.12% above what was reported in the first quarter of 2010, down from 30.8% growth the same 495 firms reported in the fourth quarter. In the fourth quarter, S&P total growth of 30.7%.
Sequential earnings growth is 3.17% for the 495 that have reported, -0.26 ex-Financials.
Growth slowdown mostly due to Financials not repeating extraordinary growth of the fourth quarter. Growth ex-Financials 19.2%, down from 19.8% in fourth quarter.

Quarterly Growth: Total Net Income Reported
Income Growth	"Sequential Q2/Q1 E"	"Sequential Q1/Q4 A"	Year over Year 1Q 11 A	Year over Year 2Q 11 E	Year over Year 4Q 10 A
Industrial Products	6.08%	17.02%	65.96%	25.49%	60.90%
Basic Materials	-0.15%	47.45%	48.26%	46.26%	47.68%
Auto	-6.36%	82.04%	46.88%	0.94%	-3.47%
Oils and Energy	11.03%	18.38%	40.59%	37.65%	40.47%
Conglomerates	8.18%	-22.35%	29.30%	13.41%	34.08%
Computer and Tech	-3.61%	-11.82%	24.84%	9.15%	26.10%
Transportation	36.07%	-16.95%	23.82%	15.72%	30.69%
Consumer Discretionary	10.84%	-20.89%	15.66%	5.41%	21.75%
Business Service	8.69%	-7.91%	12.25%	14.43%	15.50%
Finance	-6.59%	21.98%	8.74%	1.74%	161.84%
Medical	-3.92%	9.81%	5.90%	0.01%	7.60%
Retail/Wholesale	2.85%	-19.23%	5.58%	5.82%	11.42%
Aerospace	7.35%	-17.51%	5.04%	-6.24%	-3.79%
Consumer Staples	9.84%	-8.67%	3.77%	3.26%	6.90%
Utilities	-5.67%	24.35%	-1.09%	-0.07%	0.44%
Construction	208.55%	-46.96%	-34.25%	-14.88%	24.83%
S&P 500	1.23%	3.17%	17.12%	10.05%	30.75%
Excl Financials	3.57%	-0.26%	19.17%	12.55%	19.80%

Quarterly Growth: Total Revenues Reported

Revenue growth strong at 8.56%, up from the 8.31% growth posted (495 firms) in the fourth quarter. Ex-Financials growth of 10.49%, up from 8.35% in fourth quarter.
Sequentially revenues 1.84% lower than in the fourth quarter, down 1.33% ex-Financials.
Financials, Aerospace and Utilities sectors have falling revenues; seven sectors post double-digit revenue growth, Industrials and Energy grow sales over 25%.
As one would expect in an economic recovery, cyclicals are leading the way on revenue growth. Energy and Materials growth helped by strong commodity prices.