The first quarter earnings season is done. Net income growth was 17.12%. While that is down from the extremely strong 30.9% the same 495 of the S&P 500 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 it posted in the fourth quarter. Growth excluding the Financials was 19.1%, down only slightly from the 19.8% growth posted in the fourth quarter. 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.
Rate of Growth Slowing
The rate of growth is expected to continue to slow in the second quarter, with total growth of 9.33% and growth of 11.24% if the Financials are excluded. Note, however, that those year-over-year growth expectations are still higher than the expectations for the first quarter before the first quarter earnings season started.
I would be very surprised if we didn’t end up with double-digit growth on both a total and ex-Financials basis. Normally about three times as many firms will report positive surprises as disappointments, and that in turn makes the intial growth projections very conservative.
Revenue Growth Stayed Strong
Revenue growth was also very strong at 8.82%, up from the 8.31% growth the S&P 500 posted in the fourth quarter. Financials are a major drag on revenue growth; if they are excluded, reported revenue growth was 10.80%, up from the 8.35% growth posted last quarter.
Revenue growth is also expected to slow dramatically in the second quarter, falling to 0.62% year over year for the S&P 500 as a whole. Revenue growth is expected to slip to 3.13% if the Financials are excluded. Relative to 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 Slowing
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 were 9.40%, up sharply from 8.73% a year ago and from 9.02% in the fourth quarter. Strip away the Financials and the picture is somewhat different, rising to 8.90% from 8.28% a year ago and from the 8.83% 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. For the second quarter, total net margins are expected to be 9.96%, and 9.44%, excluding the Financials.
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 8.65% in 2010 and are expected to continue climbing to 9.49% in 2011 and 10.05% 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 8.28% in 2010. They are expected to rise to 8.85% in 2011 and 9.22% in 2012.
Full-Year Expectations Still Good
The expectations for the full year are very healthy, with total net income for 2010 rising to $794.0 billion in 2010, up from $544.3 billion in 2009. In 2011, the total net income for the S&P 500 should be $924.7 billion, or increases of 45.9% and 16.5%, respectively. The expectation is for 2012 to have total net income passing the $1 Trillion mark to $1.036 Trillion.
That will also put the “EPS” for the S&P 500 over the $100 “per share” level for the first time at $108.79. That is up from $57.13 for 2009, $83.33 for 2010, and $97.04 for 2011. In an environment where the 10-year T-note is yielding 2.92%, a P/E of 15.2x based on 2010 and 13.1x based on 2011 earnings looks attractive. The P/E based on 2012 earnings is 11.7x.
There has been a sharp decline in the ratio of estimate increases to estimate cuts over the last few weeks, with the Revisions ratio for 2011 falling to 1.09 from 1.42 two weeks ago and 1.89 a month ago. For 2012, the ratio is down to 1.18 from 1.67 two weeks ago and 2.03 a month ago. Most of that decline has been due to old estimate increases falling out of the sample than due to a flood of new estimate cuts.
Warning Signs Exist
We are nearing the seasonal low point in estimate revisions activity. While the numbers are still firmly in the neutral zone to slightly on the positive side, the sharp fall off is a bit of a yellow flag. If it continues to be lackluster as revisions activity picks up in a few weeks it will be a significant reason for concern.
The fundamental backing for the market continues to be solid. 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.
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 even Congress could be so stupid as to 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.
Low Government Spending Drags
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.
Economic Data Softening
The overall tone of the economic data in recent weeks has been on the soft side. We got very disappointing news from the two “mini-ISM’s” last week; the Empire State and Philly Fed reports were both far weaker than expected and showed an actual contraction in manufacturing activity in the mid-Atlantic region.
Initial Claims for unemployment insurance fell by 16,000 but remained above the key 400,000 level of the 10th week in a row. Industrial production rose only 0.1% in May and April was revised lower. However, the headline numbers there were worse than the actual situation. Most of the decline was from the Utility sector and reflected cool weather as much as a slowdown in economic activity.
Manufacturing output rose by 0.4%, recouping most of its 0.5% decline in April. The April decline was mostly due to the supply chain effects of the Japan disaster. Overall Capacity Utilization was unchanged at 76.7%, but factory utilization rose to 74.5% from 74.2%. Both measures remain well below their historical averages, but have improved substantially over the last year.
Utility output plunged 2.8% on the month and utility utilization fell to 79.0% from 81.4%, and is now below the lowest level of the recession. Inflation was also hotter than expected at the core level, with the core CPI up 0.3% versus expectations of a 0.1% increase and higher than the 0.2% level in April. Headline inflation was actually lower than core at 0.2% due to falling gasoline prices. That will probably happen again in June.
Some Data Surprised to the Upside
Not all the economic data was bad. While retail sales fell 0.2%, that was much better than the 0.7% decline that was expected. Also, housing starts were higher than expected at an annual rate of 560,000, up from 541,000 in April, and April was revised sharply higher from a 523,000 rate. Most of the strength, though, was in the volatile multi-family segment, and the absolute level is still just plain awful.
Still, there is hope that the recovery (such as it is) in residential investment will continue as building permits also rose to an annual rate of 612,000, far above the expected 548,000 level and higher than the upwardly revised 563.000 level in April. Overall, though, it looks like economic growth in the second quarter is going to look a lot more like the 1.8% level of the first quarter than a return to the 3.1% level of the fourth quarter.
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 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.
The debt crisis in Europe is not going away. There were riots in Greece protesting the current austerity measures, even as the ECB and Germany are demanding even more in order to get the next tranche of the bailout. 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. A Greek default will cause European banks to take a serious hit.
Don’t Despair
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 should trump a dicey international situation and the drama in DC (provided it turns out to be just drama, and the game of chicken does not end in tragedy).
Valuations on stocks look very compelling, with the S&P trading from just 13.06x 2011, and 11.65x 2012 earnings. That is extremely competitive with the 2.92% yield on the 10-year Treasury note. In fact, 100 (20%) of the stocks in the S&P 500 now have dividend yields higher than the T-note. 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.
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