The Earnings Picture
Second quarter earnings season is effectively over, with 497 or 99.4% of the S&P 500 reports in. 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 is another great earnings season.
The year over year growth rate for the S&P 500 is 11.9%, way off the 17.1% pace those same 497 firms posted in the first quarter. However, it you exclude the Financial sector, growth is 19.4%, 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.
Attention will now start to shift to the expected growth in the third quarter. Things are expected to slow a bit, with 12.30% growth expected overall, and 11.9% if the financials are excluded. While that is down fairly significantly from the second quarter, especially ex-financials, it is right in line with what the expectations for the second quarter were before companies started to report.
Top-line results were also very strong, with 10.45% year over year growth for the 497, actually up from the 8.77% growth they posted in the first quarter. The top-line results are even more impressive if the Financials are excluded, rising to 10.71% from the 9.49% pace of the first quarter.
Top-line surprises have been almost as good as than the bottom-line surprises, with a median surprise of 1.76% and a 2.46 surprise ratio. The revenue growth in the first half is remarkable, given only 0.4% GDP growth in the first quarter and just 1.0% in the second, with low overall inflation. High commodity prices helped revenues among the Energy and Materials sectors, and higher growth abroad and currency translation effects from a weak dollar have also helped.
Looking ahead to the third quarter, year-over-year growth of 6.16% is expected for the full S&P 500, and 6.38% growth if Financials are excluded. At the very start of reporting season, revenue growth of 9.62% total growth was expected, and 8.94% excluding the Financials.
Net Margins Growing Shakier
Net margins have been one of the keys to earnings growth, but cracks in the story are starting to appear. The 497 firms that have reported have net margins of 9.22%, up from 9.10% a year ago. That, however, is due to the Financials, especially BAC. Excluding Financials, next margins have come in at 8.58%, up from 7.95% a year ago. In the third quarter, overall net margins are expected to expand to 9.65%, and 8.54% excluding the Financials.
On an annual basis, net margins continue to march northward. In 2008, overall net margins were just 5.88%, rising to 6.37% in 2009. They hit 8.62% in 2010 and are expected to continue climbing to 9.26% in 2011 and 9.75% 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 9.16% in 2012.
The expectations for the full year are very healthy, with total net income for 2010 rising to $793.0 billion in 2010, up from $544.3 billion in 2009. In 2011, the total net income for the S&P 500 should be $916.5 billion, or increases of 45.9% and 15.6%, respectively. The expectation is for 2012 to have total net income passing the $1 Trillion mark to $1.016 Trillion, for growth of 10.9%.
That will also put the “EPS” for the S&P 500 over the $100 “per share” level for the first time at $106.59. That is up from $57.16 for 2009, $83.12 for 2010, and $96.12 for 2011.
In an environment where the 10-year T-note is yielding 1.99%, a P/E of 14.5x based on 2010 and 12.5x based on 2011 earnings looks attractive. The P/E based on 2012 earnings is 11.3x. Those P/Es are based on the Thursday close, so are even lower after Friday’s fall (and the likely decline on Tuesday given the weakness in Europe on Monday).
Estimate Revisions Past Seasonal Peak
Estimate revisions activity has past its seasonal peak. During the last seasonal decline in revisions activity, the ratio of increases to cuts also declined sharply, from over 2.0 at the height of the last earnings season, but dropped sharply after earnings season was over.
It is happening again. The revisions ratio for 2011 dropped to 0.97, which is a neutral reading, and for 2012, it is down to a bearish reading of 0.67.
Recap of Key Data and Events of Last Week
Mother Nature has certainly not been a kind old lady of late. The flooding in the Northeast is now being matched by flooding in the Southeast, while Texas burns due to no rain for ages. It was not a bad week for the market, though, at least through Thursday. Until Friday, the economic numbers were actually fairly constructive.
Housing prices in June, according to the Case-Schiller index, were effectively flat on a seasonally adjusted basis (really the way to look at them, not the unadjusted numbers that are more widely reported in the media). However, given the very high level of existing home inventories relative to sales I would not expect that to last, and would expect softness in home prices through at lest the end of the year. Not another major plunge, but more of a slow drift down.
Personal Income rose by 0.3% in July, roughly in-line with expectations. However, the quality of the income growth was higher than in previous months, with more coming from sources like wages and salaries and small business income, and less from government transfer payments.
Personal Spending was much stronger than expected, rising 0.8%. While that caused the savings rate to fall to 5.0% from 5.5%, it also argues very strongly against the economy being in a recession in July. While the savings rate is far higher than it was in the period prior to the Great Recession/Lesser Depression, it is still on the low side and needs to rise more over time.
The problem is that a rising savings rate causes economic growth to slow, and a falling one will cause an acceleration. The plunging savings rate between 1992 and 2006 was a big part of the reason the economy grew in those years. It is also a big part of the reason that the economy is in the funk it is in today.
Initial Claims for jobless benefits fell back again again, to 409,000. However, remaining above the 400,000 is not a good sign. That is the level that would indicate that the economy is producing enough jobs on balance to start to bring down the unemployment rate. Some of the decline, like the increase the week before, can be traced to the Verizon (VZ) strike that is now ended.
The ISM manufacturing Index fell to 50.6 from 50.9 in July. That was much better than the expected level of 48.5. As a “magic 50" index, it means that the manufacturing sector was still expanding in August, but just barely. Given the disastrous readings that we got from some of the regions’ “mini-ISMs,” the whisper numbers were even weaker than the official expectations of 48.5, so this was a very pleasant surprise.
However the internals of the report were not that strong, with three of the four key sub indexes (Production, Backlog and New Orders) now showing contraction, and the fourth, Employment, down by 1.7 points — but still above the 50 level. Monday we get the ISM services Index, which is expected to fall to 51.9 from 52.7. In other words, positive, but very slow growth for the service side of the economy, which is far larger than the manufacturing part of the economy.
Thus the news we had gotten for the week was pretty good, or at lest better than expected, and seemed to show no immediate return to recession. Then we got the employment report.
Friday’s Painful Jobs Report
The total number of people employed was unchanged in August, not a single job gained or lost. That is much worse than consensus expectations for a gain of 75,000. This report was also worse than the ADP report on Wednesday. That report showed 91,000 private sector jobs created, and the expectations were for the BLS to show 111,000 new private sector jobs.
The “actual” BLS number of private sector jobs was just 17,000. That slowdown was a little bit exaggerated due to the Verizon strike, but even adding those back in it was still a deeply disappointing report.
Government payrolls declined by 17,000. The Federal Government employment fell by 2,000 jobs. The State level added 5,000 but the Local levels laid off 20,000. The addition at the State level was due to the return of workers in Minnesota after a budget impasse related government shutdown.
The pace of government lay offs slowed sharply from last month when a total of 71,000 were laid off (revised from a loss of 37,000). The unemployment rate, which is derived from a separate survey, was also unchanged at 9.1%. That was in line with what the consensus was looking for.
The Household survey was noticeably more upbeat than the establishment survey. pointing to a gain of 331,000 jobs. The Civilian Participation rate rose to 64.0% from 63.9%, but is down from 64.7% a year ago. In other words, the unemployment rate was unchanged even though people were coming back into the labor force.
The percentage of people over the age of 16 who actually have jobs rose ever so slightly, to 58.2% from 58.1% (employment to population ratio, or the employment rate). However, the previous month’s levels of both the participation rate and the employment rate were the lowest since 1983, so the small increases hardly mean that happy days are here again. While the other data for the week was saying no return to recession, the most important report of the week was saying, "Yeah it might just be happening."
Earnings and Valuations Holding Up
At the micro level, earnings and valuations provide plenty of reason to be bullish. This is particularly true when one looks at the prevailing level of interest rates. Currently 233 S&P 500 (46.6%) firms have dividend yields higher than the Friday yield on the 10-year T-note (1.99%), and over two thirds (340, or 68.0%) yield more than the five-year note (0.94%). Heck, 101 or 20.2% yield more than even the 30-year bond (3.30%).
Keep in mind that 114 or 22.8% of the S&P 500 stocks pay no dividend at all, so no matter how far the market falls, they will still have a 0.0% dividend yield. Many of those companies, such as Apple (AAPL) with its $76 billion cash hoard, could easily pay a dividend if they wanted to.
Of the 386 dividend paying stocks, 60.4% yield more than the 10-year and 88.1% yield more than the five year. Those sorts of numbers have not been seen since the early 1950’s. One thing is absolutely certain: the coupon payment on those notes will never go up, while companies have been raising their dividends at a rapid pace of late.
Nearly one quarter of the firms (124) in the S&P 500 (and almost a third of those paying a dividend) have raised their dividend at more than a 10% per year rate over the last five years, and those five years include the worst economic downturn since the 1930’s. Only 72 have lower dividends than they had five years ago, and 34 of those are Financials.
The Plight of the Euro
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.
The economy remains very fragile, and is thus very susceptible to any outside shocks. There is a potential 8.5 on the Richter scale looming in Europe’s problems. There is a very real chance that the Euro will not even exist in a few years, or if it does, it will be a diminished version where the common currency only applies to Germany and the Netherlands, and perhaps France. The Greeks and the Italians would go back to having Drachma and Lira.
Getting from here to there has the potential for enormous dislocations, and hence big damage to the European economy. That would inevitably spill over to the U.S. The Greek bailout is in very serious trouble, and the yield on the Greek two-year note soared to new highs, hitting over 45%. That is way beyond junk and in the realm of radioactive waste. On the other hand, Spanish and Italian 10-year notes rallied to yield about 5% down from about 6.5% a week ago, so some of the contagion fears have subsided, at least for now.
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.
For that to happen, the overwhelming majority of people in Europe will have to think of themselves first and foremost as Europeans, not as French, German or Italian, just as most people here tend to think of themselves first and foremost as Americans, not as New Yorkers, Buckeyes or Hoosiers. Given historical, cultural and language differences, that seems unlikely to happen. It would also mean that people in Germany and the Netherlands would see a big part of their tax dollars flowing to Greece and Spain, just like people in Connecticut and New Jersey see a big part of their tax dollars flowing to Mississippi and Alaska.
If that doesn’t happen, 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.
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, Bush, Congress or even the Tea Party. 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.
Debt Ceiling Deal Hamstrings Gov’t Options
The debt ceiling deal means that the government is out of any potential options to deal with the aftermath of such a shock. Monetary policy is more or less on hold, and fiscal policy is making the situation worse, not better. Thus we are pretty much left with the natural healing process of time to get the economy back on track.
The private sector has been paying down debt and combined with low interest rates the amount people have to pay for debt service has been coming down. However at the start of the recession, the level was extraordinarily high.
Obama now says he wants to fight for jobs. He will be giving a major speech on the subject on September 5th. Unfortunately, he just bargained away all of the ammo he needs to fight with. It is not that the current round of spending cuts are that big in the short term, they aren’t. The problem is it precludes taking any other fiscal action that could help on the growth and employment front.
It is an open question still if the two measures that were taken to sustain growth this year, the payroll tax cut and the extension of unemployment benefits will even be renewed next year. If they both expire, growth will probably be about 1.0% below what it would be if they are continued, or about 0.5% lower if either one of them is allowed to lapse. In our slow growth environment, 1.0% can make a big difference.
Barring a real collapse of Europe, it now looks like 2012 will be a year of positive, but still very low economic growth. More of the pseudo-recovery where the economy grows, but unemployment remains very high, or possibly even rises a bit.
The Fed realized that at their last meeting, but only took a baby step towards addressing the problem. They finally were a bit more explicit about what they meant by “an extended period” of exceptionally low interest rates. The new provisional definition is at least until the middle of 2013, something that will keep rates very low out to the two to three year part of the curve.
However, even that baby step caused the most dissention at the Fed in my memory, with three dissents. The minutes to the meeting revealed the Fed is deeply divided on if it should even try to give the economy any more help. Most of the members of the Fed were saying that the economy is running too cold with inflation for the foreseeable future running at below optimal levels, and unemployment remaining exceptionally high for a long time.
The classic response to that would be for the Fed cavalry to ride to the rescue. Others, however, were afraid that the Fed had already gone too far, and that each step they have taken seems to have less and less effect, and that they are ultimately just pushing on a string.
Stay Invested but Don’t Shoot for the Stars
On balance I remain bullish. I am, however, pulling back on my year-end target price for the S&P 500. I had been looking for about 1400 by the end of the year (since December). With the slower economy and the turmoil on both sides of the Atlantic, something more on the order of 1325 now looks more realistic.
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 12.0x 2011, and 10.5x 2012 earnings.
Put in terms of earnings yields, we are looking at 7.98% and 8.85%, while T-notes are only at 1.99%. 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 note. 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.
Even based on the 10-year trailing P/E, which includes two periods of very depressed earnings, and does not take into consideration interest rates, stocks are just about fairly valued. Long-term investors should start to take advantage of the current valuations. However, I would not be shooting fro 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. 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.
If such a company has been able to maintain a dividend growth rate of 15%, then your yield on cost at the end of those five years will be over 5.0%, and over 10% after ten years. Not a flashy strategy, but one that could provide you with a very nice income to retire on.
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