AFL AFLAC Inc

The Earnings Picture

Second quarter earnings season is over; the attention now shifts to the third quarter. 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 has been another great earnings season.

The year-over-year growth rate for the S&P 500 is 11.9%, way off the 17.1% pace posted in the first quarter. However, it you exclude the financial sector, growth is 19.3%, actually up slightly from the 19.1% pace of the first quarter. At the beginning of earnings season, growth of 9.7% was expected, 12.2% ex-financials.

The outlook for the third quarter now looks very similar to the outlook for the second quarter three months ago, with net income growth of 11.4% expected for both the total and excluding the financials. We will need another season where positive earnings surprises far outpace disappointments if we are going to match the second quarter growth rate. On the top line, growth is also expected to slow sharply, to 5.59% in total from 11.05% in the second quarter, and excluding the financials to 9.18% from 13.16%.

Net Margin Forecast

Expanding net margins have been one of the keys to earnings growth. In the second quarter, total net margins were 9.14%, and excluding financials they were 9.13%, up from 9.10% and 7.95 ex-financials in the second quarter of 2010. In the third quarter, the financials net margins are expected to recover (we will see about that -- depends on the level of net charge-offs at the banks, which are sort of hard to predict).

Thus, total net margins are expected to rise to 9.60%, while excluding financials they are expected to drop to 8.94%. Then again, revenue growth is expected to be much lower for the financials.

On an annual basis, net margins continue to march northward. In 2008, overall net margins were just 5.88%, rising to 6.37% in 2009. They hit 8.62% in 2010 and are expected to continue climbing to 9.24% in 2011 and 10.01% 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 7.04% in 2009, but have started a robust recovery and rose to 8.23% in 2010. They are expected to rise to 8.76% in 2011 and 9.24% in 2012.

Full-Year Expectations

The expectations for the full year are very healthy, with total net income for 2010 rising to $793.0 billion in 2010, up from $543.6 billion in 2009. In 2011, the total net income for the S&P 500 should be $914.1 billion, or increases of 45.9% and 15.3%, respectively.

The expectation is for 2012 to have total net income passing the $1 Trillion mark to $1.042 Trillion, for growth of 14.0%. That will also put the “EPS” for the S&P 500 over the $100 “per share” level for the first time at $109.22. That is up from $56.95 for 2009, $83.10 for 2010 and $95.81 for 2011.

In an environment where the 10-year T-note is yielding 2.05%, a P/E of 14.6x based on 2010 and 12.6x based on 2011 earnings looks attractive. The P/E based on 2012 earnings is 11.1x.

Estimate Revisions Near Seasonal Low

Estimate revisions activity is near a seasonal low. What has really been drying up is estimate increases, as those made immediately after the second quarter positive earnings surprise roll-off the four-week moving total I track. The number of cuts has also declined, but not nearly as sharply and as a result the ratio of increases to cuts is now at a very bearish level of 0.52.

This has been very widespread; the ratio of firms with rising mean estimates to falling is down to 0.64 for this year and to 0.43 for next year, and almost every sector has more cuts than increases for both this year and next (the one exception is a tie in the Auto industry for this year, but on an extremely small sample).

In light of the generally downbeat economic news, it is not surprising that we are not seeing a lot of estimate increases without the catalyst of positive earnings surprises. During slow revisions periods, the revisions ratio is generally less significant that during periods of high activity, but that does not mean that it should be ignored completely, and it is flashing a yellow caution light pretty brightly now.

The strong earnings performance we have seen, particularly in large multinational company earnings (like most of the S&P 500 I track in this report) is the single most important argument in the bulls' favor (along with the low valuations based on those earnings). Thus if that starts to crack in a big way, it would be a very big concern.

Recap of Key Data and Events

The economic news this week was mostly, but not entirely, on the downbeat side. Retail sales came in flat for the month, below expectations for a 0.2% increase, and July’s numbers were revised down. The government’s tally of auto sales was lighter than one would have expected based on what the auto companies reported, and the numbers for ex-autos also came in lighter than expected, rising 0.1% rather than the 0.3% the consensus was looking for.

Industrial Production

We did get some somewhat better than expected news from the report on industrial production and capacity utilization, particularly if one backs out the weather related effects on utility output. The absolute numbers were not great, but still moving in the right direction and it was better than expected.

On the other hand, inflation ran a bit hotter than expected, mostly due to gasoline prices. The headline CPI rise 0.4% in August, rather than the 02% rise that was expected. However, if food and energy are stripped out, prices rose only 0.2%, in line with expectations.

Fed Meeting Coming Up

The higher headline number will probably give ammunition to those on the Fed who don’t want it to do any more to ease monetary policy. The Fed is deeply divided, and it having a two-day meeting this week to hash things out. The statement due out on Wednesday afternoon will be carefully parsed for clues as to its future direction. One of the key details will be the number of members who dissent. Last time there were three, an unusually high number.

Jobless Claims

Initial Claims for jobless benefits rose again, to 428,000. Some of that might been due to Hurricane Irene, but even so, it is not a very good sign. We really need to see that number fall below the 400,000 level to indicate the job market is returning to health. Given the severity of the jobs crisis, it will take some time to heal, even after we get below that level, and we are moving in the wrong direction. This is not a good sign.

American Jobs Act

I seriously doubt that the “American Jobs Act” which Obama proposed last week will pass. Thus we are not going to get a lot of help from fiscal policy in bringing down unemployment. The GOP in the House is simply too fixated on bringing down the deficit to spend anything on getting job growth going again, even though the vast bulk of the package is tax cuts. However, it would largely be paid for by other tax increases.

The shift in the tax burden makes a lot of sense to me. It would eliminate lots of special interest deductions that mostly benefit the very top of the income distribution, and provide a boost to the take-home pay for the vast majority of workers. It would do so by increasing the size of the payroll tax cut from 2% of the first $106,800 someone earns to 3% on the individual side, and also introduce cuts in the payroll tax on the employer side, particularly targeted at small businesses. For the median household (including households of one) that would mean about $500 more in after tax income than in 2011.

In contrast, if nothing is done the 2011 payroll tax cut will expire, and the median household will have $1,000 less to spend. That would be a huge hit to consumer demand (about 70% of the economy) and would result in even more unemployment.

While small businesses and their owners are often referred to as the "job creators," that is not really the case. Yes, historically most new paychecks have been signed by the owners of small businesses, but no business -- large of small -- is going to hire people if they don’t think that there are customers for their goods or services. It is customers who are the job creators, not businesses.

It is uncertainty about the number of customers, not about taxes or regulations, which are keeping businesses from hiring. We learned this week that in 2010, real median income dropped 2.3% from 2009 levels and is now 6.4% below where it was at the start of the Great Recession and 7.1% below its 1999 peak. We also learned that the poverty rate rose to 15.1% in 2010 from 14.3% in 2009, and from 12.5% in 2007 before the start of the Great Recession. People in poverty do not make great customers, and thus are not very good job creators.

Austerity Measures and the "Super Committee"

The thrust of the “American Jobs Act” runs directly counter to the thrust of debt-ceiling deal. The “Super Committee” of six Democrats and six Republicans which is charged with coming up with $1.5 Trillion in deficit reduction over the next decade is on the road to failure.

If it cannot come up with an agreement by November 23rd, or if Congress does not pass the package by December 23rd, then automatic spending cuts of $1.2 Trillion kick in. Half of those would be to defense, and half to non-defense (mostly discretionary) spending. That is a "meat cleaver" approach and will be front end loaded, with big cuts starting in 2013.

There are three entitlements that really matter in the budget: Social Security, Medicare and Medicaid. Social Security has its own dedicated tax, and since 1983 that tax has provided more revenues than Social Security has paid out. The difference was invested in the safest possible security: U.S. government bonds.

The Social Security Trust Fund created by that excess now stands at $2.7 Trillion. It is a substantial portion of the $14.8 trillion federal debt, but it is debt that the government in effect owes to itself. Under the medium economic assumptions, it is able to pay out all benefits as scheduled until 2037, and thereafter can pay out 78% of scheduled benefits forever. Because the benefits are tied to average wages rather than to inflation, the real value of that 78% is expected to be higher than the current beneficiaries get.

The payroll tax is a highly regressive tax, one levied on the very first dollar of income someone makes, but stopping for earnings after $106,800. Thus high income workers see a jump in their take-home pay after their earnings for the year have passed the threshold. By building up the trust fund, lower-income workers have in effect been subsidizing the rest of the budget.

The bulk of what we think of as the Federal Government; the Pentagon, the Federal Court System, and the complete alphabet soup of agencies are theoretically paid for out of other taxes, most notably the income tax, both individual and corporate. The budget deficit numbers you hear bandied about are the combination of both Social Security and the rest of Government. Thus, since the Social Security system has been running a surplus, the deficit from the rest of Government is actually much larger than advertized.

While the overall budget has been in deficit almost always since at least the 1930’s, generally until 1980 (with the big exception of WWII) it has been a lower percentage of GDP than the growth rate of GDP. Thus it is easily rolled over, and as a share of the economy it is shrinking.

Cutting Medicare and Medicaid

That leaves Medicare and Medicaid as the only places where there is enough spending to really cut $1.5 Trillion. There are really two ways to cut those programs, either reducing who they cover, or what they cover. I favor the latter approach. That, however, would mean that the programs would have to be able to determine which medical procedures were both effective medically, and which were also cost effective.

The ACA started to move in that direction, but was met with cries of “death panels," and overly intrusive government involvement in health care decisions. On the other hand, if we start reducing who is covered, say by increasing to 67 from 65 the age at which you can get Medicare, the number of people without health insurance at all will skyrocket. As it is, 16.3% of all Americans, or almost 50 million people, have no health insurance coverage at all. That is up from 16.1% in 2009.

Because of Medicare, though, very few people over age 65 are without coverage. The uninsured rate is 18.4% for those under 65, up from 18.2% in 2009. It is estimated that over 40,000 people die each year in this country because they lack any access to health care (other than emergency rooms, which are very expensive and ultimately paid by tax payers, and don’t tend to catch longer-term health issues). For more on the poverty report see here.

If taxes are off the table entirely, then I think that we will end up with the Super Committee in a stalemate, and we will get the $1.2 Trillion in meat-cleaver cuts. That is not going to raise anybody’s confidence and will be a body blow to the economy.

Yet the Markets Went Higher

Despite the generally bad economic news, the market was up every day last week. I think it was mostly due to the valuations simply being too compelling to ignore. It has been a very long time (with the exception of the very depths of the financial crisis) since the dividend yield on the S&P 500 was higher than the 10-year T-note.  Money has to be parked somewhere, and equities look a lot more attractive to me than bonds -- especially government bonds -- or real estate.

We also got some better news on the European front. I would not count on that lasting, though. Perhaps the can might be kicked down the road a little bit further, but it strikes me that Greece is bound to default, and that the Euro is destined to fail as a common currency. What really is in doubt is when, not if.

Pricing In Another Recession

At these levels it is clear to me that the market is pricing in not just slower growth, but an outright recession, either underway or just about to get underway. If it turns out that we avoid an outright recession, and the decline in profits that usually comes with one, then the market should rally from here.

As I noted above, the expectations are starting to come down, particularly for 2012, but the vast majority of stocks, and every economic sector is expected to earn more in 2012 than in 2011. The decline in the revisions ratio is mostly driven right now by the drying up of new estimate increases, rather than a flood of new estimate cuts. It is entirely normal at this point seasonally for overall revisions activity to slow down dramatically. 

Of Euros, PIIGS and Unscrambling Eggs

The demise of the Euro has the potential for enormous dislocations, and hence big damage to the European economy. That would inevitably spill over to the U.S. If it were just Greece, perhaps the damage could be contained, as it really is not that big. However, there are still big concerns about the rest of the PIIGS.

The economy of Greece, in particular, but also for the rest of the periphery of Europe continue to weaken, and with that weakness tax revenues are drying up even more, and the country is missing the fiscal targets it agreed to just a few months ago.

Ultimately, one of two things is going to have to happen: Either fiscal policy will have to be consolidated in Europe as a whole (which means that the individual countries will have to give up most of their sovereignty -- essentially Italy will have to become like Florida, and Germany like California), or the common Euro currency has to fall apart. Italy and Greece, unlike the U.S. do not have their own printing press (hence when they get downgraded, their interest rates soar, not sink like here). They have to rely on the printing press of the ECB, and that is largely controlled by the Germans.

The process of unscrambling the Euro egg and going back to Drachmas and Lira would be a very messy one, and will result in huge dislocations, and thus could potentially cause economic collapse. Most of the proposals that would integrate Europe fiscally would take a long time, and would probably require not just passage by each of the 17 parliaments that use the Euro, but probably changes in their constitutions as well.

That is not going to happen overnight. It also means that it is highly unlikely that the Euro, the second-most-important currency in the world, is going to strengthen dramatically against the dollar.

European banks are heavily invested in the bonds of the PIIGS, and there is a real threat to the stability of the European banking system. If the European banking system goes down, ours will follow as night follows day (or at the very least we will need to see "Son of TARP"). This is not a problem caused here, and is not the fault of Obama, or GW Bush, or Congress or even the Tea Party, for that matter. It is a mess of the Europeans own making, but its effects will be felt here, just as the effects of the mortgage mess of our making were felt there.

Stay Invested but Don’t Shoot for the Stars

On balance I remain bullish. My year-end target remains at 1325 for the S&P 500. Getting there is going to be a bumpy ride. Strong earnings should trump a dicey international situation and the drama in DC. Valuations on stocks look very compelling, with the S&P trading from just 12.6x 2011, and 11.1x 2012 earnings.

Put in terms of earnings yields, we are looking at 7.92% and 9.03%, while T-notes are only at 2.05%. The old “Fed Model” suggested that the forward earnings yield (call it 8.45%) should be in line with the 10-year note. Instead we have the dividend yield on the S&P 500 higher than the 10-year.

Since the early 1950’s that has happened only twice, in early November of 2008 and in March of 2009. The second incident was followed by a doubling of the S&P 500. From a long-term perspective, stocks look extremely undervalued to me.

Long-term investors should start to take advantage of the current valuations. However, I would not be shooting for the stars. Look for those companies with solid dividends (say, over 2.5%), low payout ratios, solid balance sheets and a history of rising dividends, which are still seeing analysts raise their estimates for 2012, or are at least not cutting them aggressively.

Currently, firms like Abbott Labs (ABT), Aflac (AFL), Genuine Parts (GPC) and Johnson & Johnson (JNJ) would fit that description. I don’t know if you will be happy doing so next week or even next month, but I am pretty sure that you will be quite satisfied five years from now if you do so.
 
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