The first quarter earnings season is almost done. We now have 458
(91.6%) of the S&P 500 reports in. We have enough of a sample
now to be pretty sure this will be a good earnings season.
So far, we have income growth of 17.9%. While that is down from the
extremely strong 32.4% those same 458 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.
Tougher Comps for Financials
It’s not that the Financials are having a bad quarter, but they do
face much tougher comps this time around. It is not like the 8.7%
year-over-year growth they are reporting is 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 19.9% so far,
down just slightly from the 20.4% those firms reported in the
fourth quarter. Looking ahead to the second quarter, growth is
expected to continue to slow, but remain in the double digits at
10.7%. Back out the Financials and growth is expected to be
13.1%.
Revenue growth is also very strong at 9.38%, up from the 9.03%
growth they posted in the fourth quarter. Financials are a major
drag on revenue growth; if they are excluded, reported revenue
growth is 12.14%, up from the 9.26% growth posted last quarter.
Revenue growth is also expected to slow in the second quarter,
falling to 4.62% year over year for the S&P 500 as a whole.
That is mostly a Financial story. Revenue growth is only expected
to slip to 9.33% 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 9.86%, up sharply from 9.18% a
year ago and from 9.31% in the fourth quarter. Strip away the
Financials and the picture is somewhat different, rising to 8.57%
from 7.88% a year ago and from the 8.32% reported in the fourth
quarter.
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 76.1%. Three other sectors are posting
growth over 40%: Materials (48.3%), Autos (46.9%) and Energy
(40.5%).
Construction is without a doubt the weakest of the sectors, with
total net income plunging 34.3% from a year ago. The only other
sector will declining net income are the Utilities, down 1.2% from
a year ago. Anemic -- but positive -- growth of 3.5% has been
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 8.60% in 2010 and are expected to continue climbing to
9.48% in 2011 and 10.17% 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 8.82% in 2011 and 9.31% in 2012.
Full-Year Expectations
The expectations for the full year are very healthy, with total net
income for 2010 rising to $792.4 billion in 2010, up from $544.7
billion in 2009. In 2011, the total net income for the S&P 500
should be $922.7 billion, or increases of 45.4% and 16.4%,
respectively. The expectation is for 2012 to have total net income
passing the $1 Trillion mark to $1.046 Trillion.
That will also put the “EPS” for the S&P 500 over the $100 “per
share” level for the first time at $109.74. That is up from $57.12
for 2009, $83.10 for 2010, and $96.82 for 2011. In an environment
where the 10-year T-note is yielding 3.22%, a P/E of 16.2x based on
2010 and 13.9x based on 2011 earnings looks attractive. The P/E
based on 2012 earnings is 12.3x.
Analysts Upping Estimates
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.
Still, the flood of estimate increases is impressive, with the
revisions ratio sitting at 1.92. With total estimate revisions
activity soaring, that increase is overwhelmingly being driven by
new estimate increases, not from old estimate cuts falling out of
the four-week moving totals. A few weeks from now, that will not be
the case as revision activity will plunge.
Changes in the revisions ratios are more significant when activity
is rising than when it is falling (since it reflects new
information). The estimate increases are widespread, with the ratio
of firms with rising mean estimates to firms with falling estimates
standing at 1.98. There is no “mechanical” reason for the estimates
for 2012 to be rising.
The 2012 revisions ratio is now at 2.06, meaning that upwards
estimate revisions are outpacing cuts by more than 2:1 for next
year. The ratio of rising-to-falling mean estimates stands at 1.93.
Those are extremely bullish readings.
Fundamentally Good News, but Not All Smooth
Sailing
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.
Earnings are, and are going to remain, the single most important
thing for the stock market. Interest rates are an important -- but
distant -- second.
That does not mean that all is smooth sailing ahead. 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.”
The fight over raising the debt ceiling is now underway. 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.
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, 75 of the total 130 basis point growth slowdown
(57.8%) was due to increased austerity in Government spending.
Job creation remains sluggish, but had been starting to show signs
of picking up. We created 268,000 jobs in the private sector in
April, up from 231,000 in March, and 260,000 in February, but that
is after a big upward revision to the February numbers. However,
governments laid off a total of 24,000 people for the month, on top
of 10,000 pink slips the month before.
Recently, though, the trend in Initial Claims for Unemployment has
taken a nasty turn for the worse, with the four-week moving average
moving back above the 400,000 level. While we got some relief this
week, with a drop of 43,000 new claims, we need to see that number
continue to decline. Those numbers were not reflected in the April
jobs report, but they are not a good omen for the May report.
Unemployment Rate
The unemployment rate bounced back up to 9.0%. This was not due to,
as many assume, people coming back into the labor force. It was due
to the fact that the unemployment rate is derived from a separate
survey from the one that measures the number of jobs gained or
lost. The civilian participation rate has been stuck at the same
low 64.2% level since January.
Given that the unemployment rate has been higher than that in just
6.17% of the months since 1960, 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.
International Concerns Remain
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 first quarter, although much of that
growth will be made up later in the year as the reconstruction
process gets underway. Many U.S.-made products have parts which are
made in Japan, and that is likely to disrupt production here.
Still, there appeared to be no impact on Industrial Production in
March as manufacturing output climbed 0.7%. The turmoil in the
Middle East is not going away, and that is likely to keep oil
prices both high and volatile. High oil prices will also act as a
depressing force on the economy.
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. The
austerity campaigns have weakened those economies and undermined
tax revenues, and so the bailouts have not made the situation much
better.
Here at home, the housing situation has not been showing many signs
of improvement, and I doubt we will see much in the housing-related
numbers due out this week. Note that the Construction sector is the
weakest in terms of both surprises and estimate revisions.
Remaining Bullish Overhead
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.
As far as individual stock picks are concerned, look for the
combination of a Zacks #1 Rank, with moderate P/Es and a reasonable
dividend yield. The current issue of Earnings Trends has a list of
the firms with the largest positive revisions for this year.
The best hunting ground for such firms seems to be in the
Industrial, Materials and Energy sectors, but things are not
limited to them. Some of the names to consider among the S&P
500 include
AK Steel (AKS),
Caterpillar (CAT),
Cummins (CMI),
Dow Chemical (DOW),
United Health
(UNH) and
Valero (VLO).
AK STEEL HLDG (AKS): Free Stock Analysis Report
CATERPILLAR INC (CAT): Free Stock Analysis Report
CUMMINS INC (CMI): Free Stock Analysis Report
DOW CHEMICAL (DOW): Free Stock Analysis Report
UNITEDHEALTH GP (UNH): Free Stock Analysis Report
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