The first quarter earnings season is off to a strong start. We now have 147 (29.4%) of S&P 500 reports in. That actually understates things a bit, since the firms that have already reported are larger and more profitable than average and represent 43.0% of the total expected earnings for the quarter. It will pick up steam this week, when 181 members of the S&P 500 are due to report.
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 17.2%. While that is down from the extremely strong 38.8% those same 147 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. If we take out the Financials, total net income is up 19.6% so far, down just slightly from the 20.7% those firms reported in the fourth quarter.
The expectations for the remaining firms have been rising, but the hurdle is not particularly high. The consensus is looking for a significant slow down in growth for the remaining firms, with total net income rising just 9.5%, down from 25.5% in the fourth quarter. Excluding the Financials growth of 10.8% is expected, down from 19.2% in the fourth quarter.
A big part of the deceleration in year-over-year growth has to do with a much higher base, particularly in the Financials in the first quarter of 2010 than in the fourth quarter of 2009. The expected firms have not yet benefited from positive surprises the way the firms that already have reported have. In terms of surprises, this has been a very strong season so far, with a median surprise of 5.00% and a 5.09 surprise ratio.
Revenue Growth Slowing
Revenue growth so far is just so-so at 5.01%, down from the 7.41% growth they posted in the fourth quarter. The firms yet to report are expected to post year over year revenue growth of 6.00%, down from 8.66% growth in the fourth quarter. Financials are the key reason for the slowdown in revenue growth, if they are excluded, reported revenue growth is 11.52%, actually up from the 9.94% growth posted last quarter. The non-financials yet to report are expected to see growth of 7.87%, a slight acceleration from the 7.73% growth in the fourth quarter.
Net margin expansion has been a driver of earnings growth, but that expansion is slowing down, particularly if one excludes the Financials. Net margins for those yet to report are expected to come in at 7.71% in the first quarter, up from 7.41% a year ago, and from 7.51% in the fourth quarter. Excluding the Financials, net margins are expected to rise to 7.41% from 7.21% a year ago, but down from 7.58% in the fourth quarter.
Among those that have already reported for the first quarter, overall net margins are 12.65% — up sharply from 11.33% a year ago and from 11.98% in the fourth quarter. Strip away the Financials that have already reported and the picture is somewhat different, rising to 11.70% from 10.91% a year ago and from the 11.87% reported in the fourth quarter.
Cyclicals to Lead Growth
The more cyclical parts of the economy will be leading the growth charge this quarter. The highest expected growth (among those yet to report) comes from the Materials sector, where earnings are expected to be up 59.8%, although among the reports that are actually in net income is up by “just” 29.6%. The Industrials are in second place with 44.5% growth expected among those yet to report, and the total net income of those that have actually reported up 65.2%.
The Energy sector is off to a bit of a slow start, with reported growth of just 9.1%, but the remaining firms (including most of the big ones) expected to show growth of 35.6%. The Construction sector shows the opposite profile, with 58.3% growth reported so far, but the remaining firms expected to show a drop of 27.1%.
The weakest sector by far is Utilities, with total income down (so far) 3.6% from last year. Not that much is expected to change as the remaining Utilities are expected to see income drop 3.08%.
On an annual basis, net margins continue to march northward. In 2008, overall net margins were just 5.88%, rising to 6.40% in 2009. They hit 8.59% in 2010 and are expected to continue climbing to 9.53% in 2011 and 10.25% 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 8.85% in 2011 and 9.35% in 2012.
Full Year Expectations
The expectations for the full year are very healthy, with total net income for 2010 rising to $792.0 billion in 2010, up from $545.1 billion in 2009. In 2011, the total net income for the S&P 500 should be $917.5 billion, or increases of 45.4% and 15.8%, 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 $109.71. That is up from $57.17 for 2009, $83.12 for 2010, and $96.28 for 2011.
In an environment where the 10 year T-note is yielding 3.40%, a P/E of 16.1x based on 2010 and 13.9x based on 2011 earnings looks attractive. The P/E based on 2012 earnings is 12.2x.
With far more estimates being raised than being cut (revisions ratio of 1.54), one has to feel confident that the current expectations for 2011 will be hit, and more likely exceeded. Analysts are raising their 2012 projections at an even higher rate, with a revisions ratio of 1.91, or almost two increases for every cut. While a lot can happen between now and the time the 2012 earnings are all in, upward estimate momentum means that the current 2012 earnings are more likely to be exceeded than for them to fall short. This provides a strong fundamental backing for the market to continue to move higher.
Not All Smooth Sailing
That does not mean that all is smooth sailing ahead. We managed to avoid a government shutdown, but only at the cost of large spending cuts that will slow the economy. Those should probably shave at least a half point off of the growth we would have had in 2011, and probably result in hundreds of thousands fewer jobs being created. Fortunately, the economy has some upward momentum, so the cuts will simply slow the economy down, not throw it into reverse.
The lower growth will result in lower tax collections, so the impact on the budget deficit will be much less than the amount advertised. Job creation remains sluggish, but is starting to show signs of picking up. We created 230,000 jobs in the private sector in March, down from 240,000 in February, but that is after a big upward revision to the February numbers.
However, State and Local governments laid off a total of 15,000 people for the month, on top of 46,000 pink slips the month before. The idea that one can reduce unemployment by cutting jobs is positively Orwellian.
The household survey has been much more upbeat, showing growth of 291,000 jobs in March, on top of 250,000 gained the month before. The unemployment rate fell to 8.8%, and it was as high as 9.8% as recently as November.
Initernational Difficulties
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. The housing situation is still dire, even if new home sales were a bit better than expected in March at 300,000. That is still one of the lowest levels on record, and less than half of a “normal” new home sales pace. Prices of existing homes continue to fall, and with them the housing equity wealth that makes up the bulk of the wealth of the middle class.
On the plus side, the dollar has been weak, and that should improve the trade deficit, and that will be a significant positive for the economy. The foreign operations of U.S. companies will be much more profitable when the results are measured in dollars. Inflation, other than in food and energy, is well contained, up only 0.1% in March and 1.2% year over year. That should let the Fed stay on easy street as far as monetary policy is concerned.
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. The more cyclical sectors should be leading the way. Overweight Industrials, Energy and Materials; underweight Utilities and Staples.
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