The Earnings Picture
Second quarter earnings season is almost over, with 459 — 91.8% — of the S&P 500 reports in. With the exception of a handful of financial companies, 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 12.2%, way off the 17.5% pace those same 459 firms posted in the first quarter. However, it you exclude the Financial sector, growth is 20.5%, actually up from the 19.8% pace of the first quarter.
The 91.8% reported figure slightly understates how far we are along in earnings season. If all the remaining firms were to report exactly in-line with expectations, we now have 93.4% of the total earnings in. At the beginning of earnings season, growth of 9.7% was expected, 12.2% ex-Financials.
Top-line results are also off to a very strong start, with 11.86% year-over-year growth for the 459, actually up from the 9.40% growth they posted in the first quarter. The top-line results are even more impressive if the Financials are excluded, rising to 12.16% from the 10.30% pace of the first quarter.
Top-line surprises have been almost as good as than the bottom-line surprises, with a median surprise of 1.92% and a 2.52 surprise ratio. The revenue growth in the first half is remarkable, given only 0.4% GDP growth in the first quarter and just 1.3% 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.
For those (41) still to report, the rate of growth is expected to be well below what we have seen already, with growth of 8.9%, in total and 5.4% ex-Financials. I suspect that the actual growth will be somewhat higher than is now expected.
With nine sectors now done, the sample of remaining firms is very skewed. Retail alone accounts for 54.4% of all remaining expected earnings, and Tech accounts for an additional 28.4%. Wal-Mart (WMT) alone accounts for 24.5% of remaining earnings. Revenue growth for the remaining firms is also expected to slow, rising 3.85% among those yet to report, down from 4.82% they reported in the first quarter.
Net margins have been one of the keys to earnings growth, but cracks in the story are starting to appear. The 459 that have reported have net margins of 9.68%, up from 9.65% a year ago. That, however, is due to the Financials, especially BAC. Excluding Financials, next margins have come in at 9.01%, up from 8.38% a year ago.
The higher margin firms have reported early, and traditionally retail is the lowest-margin sector. The remainder of S&P 500 are expected to post net margins of 4.93%, up from last year’s 4.88%.
Net Margins Keep Improving
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 8.64% in 2010 and are expected to continue climbing to 9.32% in 2011 and 9.77% 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 7.07% in 2009, but have started a robust recovery and rose to 8.27% in 2010. They are expected to rise to 8.82% in 2011 and 9.18% in 2012.
The expectations for the full year are very healthy, with total net income for 2010 rising to $795.0 billion in 2010, up from $544.3 billion in 2009. In 2011, the total net income for the S&P 500 should be $922.1 billion, or increases of 45.5% and 16.0%, respectively. The expectation is for 2012 to have total net income passing the $1 Trillion mark to $1.022 Trillion, for growth of 10.2%.
That will also put the “EPS” for the S&P 500 over the $100 “per share” level for the first time at $106.99. That is up from $57.15 for 2009, $83.17 for 2010 and $96.43 for 2011. In an environment where the 10-year T-note is yielding 2.25%, a P/E of 14.1x based on 2010 and 12.2x based on 2011 earnings looks attractive. The P/E based on 2012 earnings is 11.0x.
Estimate revisions activity is near its seasonal peak. During the 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, to slightly below 1.0 for both this year and next. Now as activity is ticking up, so are the revisions ratios standing at 1.62 (up from 1.61 last week) for 2011 and 1.41 (unchanged from last week) for 2012.
The Bigger Picture
To say it this was a wild week in the market is sort of like Noah saying “It looks like Rain.” After a very rough week the week before, the market plunged last Monday. Some commentators blamed the plunge on the S&P debt downgrade. I really don’t think that was the case.
There were also major problems, and rumors of even more serious problems, in Europe during the week. Starting with Italy and Spain being now more in the category of countries that need saving, rather than being among the group of countries that do the saving of the more troubled smaller countries like Greece and Ireland. Later in the week there were unconfirmed rumors that one of the largest banks in France, Societie General, or SoGen, was on the ropes. At this point, rumors are all that they are, but if SoGen were to go down, it would be the European equivalent of the fall of Lehman Brothers.
Bonds Say: It’s Not About the Downgrade
The action in the U.S. market particularly the week before and in the early part of the week bore all the hallmarks of fears that economic growth expectations are too high and need to come down. If it had really been about the S&P downgrade, what we would have seen is a sell-off in the bond market and interest rates spiking. That is what normally happens when you get a downgrade, in the Corporate or Muni bond market.
Even in the Sovereign debt market, when a country like Greece or Portugal gets downgraded, investors flee the debt and interest rates rise sharply. That did not happen here. Instead we saw a stunning rally in the bond market and yields plunging, along with a plunging stock market.
It was not really a big drop in the inflation expectations component of interest rates, but a plunge in the real rate. The previous Friday, before the debt downgrade, the yield on the 10-year Treasury was 2.58%, an extremely low level by any historical standard. The 10-year Treasury Inflation Protected Security (TIPS) was at just 0.32%. That is the real interest rate component of the yield, the difference between the two is the market’s expectation of future inflation, or 2.26%.
By Wednesday, The yield on the regular T-note was down to 2.17%, and the 10-year TIPS had fallen to -0.13%. While TIPS have been around only since the start of 2003, that was a very significant day. It was the first time in history that the 10-year real interest rate had fallen to negative territory.
Negative Real Rates = Low Growth Forecast
In other words, in real terms, people are actually paying for the privilege of lending to the U.S. Treasury. The expected rate of inflation, the difference between the two (and without a doubt, the best measure of inflation expectations around, because it is market- rather than survey-based) actually rose slightly, to 2.30%.
Something similar happened at the five year, although real interest rates there have been negative since the end of March. The yield on the 5-year TIPS dropped to -1.02% from -0.59% before the downgrade. The yield on the 5-year T-note fell to 0.93%. The expected rate of inflation rose to 1.95% from 1.82% before the downgrade. At the start of the year, the TIPS rate was 1.05% for the ten year and 0.20% for the five year, while the rates on regular T-notes were 3.36% and 2.02%, respectively.
Inflation to Stay Low
I would note that even though the inflation expectations rose for both the next five years and the next 10 years, they still imply rates of inflation that are lower than we have experienced on average over the last 10 years, 20 years, 30 years and 40 years. Sure there are lots of pundits out there who point to things like the rise in the price of gold and the expansion of the Fed’s balance sheet and say we are just around the corner from high inflation or even hyperinflation like in Zimbabwe or the Weimar Republic.
The bond market emphatically disagrees. Here is a graph of the five and ten year T-note yields and the equivalent TIPS ever since the TIPS were introduced. The spike in TIPS prices during the meltdown of late 2008 is mostly due to the TIPS market being smaller and less liquid than the regular T-note market (well, isn’t just about everything smaller and less liquid than the regular T-note market?).
In times of stress, T-note are still going to be the first place that institutions look to park money when they want to flee to a safe place, regardless of what S&P says about how safe they are. There are simply no other markets that are big enough to do the job. Not the Swiss Franc, not gold, not AAA corporates. All of them are simply too small.
S&P downgraded Japan a long time ago, and their long-term bond rates are even lower than ours are and have been since they were downgraded. Are the Chinese going to dump their Treasuries? NO. What would they do with the money if they did? Buy bonds in euros or yen? If they did that they would have to sell dollars and buy either yen or euros.
That would weaken the dollar and strengthen those currencies, making our exports cheaper and imports more expensive, and thus lower our trade deficit. That would be a very good thing for the economy. Go ahead China, make our day and sell your T-notes.
Political Default Possible?
Does that sound to you like a crisis in confidence about the ability of the U.S. government to repay its debts? It sure doesn’t to me. Rather what it suggests is that economic growth is going to be much lower than people expected. Real interest rates usually reflect the rate of growth in the economy.
What the market really fears is not the deficit, or the accumulated debt, but that the misguided austerity measures now underway not only here but across the Atlantic are going to further slow growth. That the S&P downgrade, to the extent it matters at all, will be used by politicians to argue for yet more job-killing spending cuts.
One thing bears repeating: as long as the U.S. debt is denominated in dollars, the only possible reason for the U.S. government to default is a political decision to do so. The government owns a printing press that is legally allowed to print as many dollars as it wants. Could that be inflationary? Of course it could, but as I noted above, the people in the bond market are betting very big bucks that inflation is not a serious concern right now or in the foreseeable future.
The downgrade came because we actually had members of Congress saying that maybe we should default on our debt, or at least default on other commitments that the government has made. Effectively they were arguing that default would be a good political decision to make.
Set Up for Failure
We managed to avoid an economic end of the world scenario when Congress passed a last-minute raising of the debt ceiling. It only happened because President Obama caved in (he could have just invoked the 14th Amendment and told the Tea Party to go jump in a lake). In effect, the Tea Party had held the economy hostage, and in the end Obama decided to pay a ransom.
That ransom was about $1 Trillion in spending cuts over the next decade, and the formation of a “Super Committee” to identify an additional $1.5 Trillion in deficit reduction over the next decade. If the Super Committee reaches an impasse by their deadline (just before Thanksgiving) or Congress does not pass their plan (by Christmas), $1.2 Trillion of spending cuts will automatically go into effect.
While the first part of the spending cuts are back-end loaded, with almost no spending cuts for the rest of 2011 and minimal cuts for 2012, the same is not true of the $1.2 Trillion, which is a meat-cleaver approach and is very front-end loaded. Those cuts will kill the economy, which in turn will depress tax revenues by throwing us back into recession and in the end might well result in a higher, not lower deficit.
In other words, there is another hostage ripe for the taking. If you enjoyed the debt-ceiling circus and are sad that the show is over, don’t worry — there will be an encore performance just before Thanksgiving. It seems clear to me that the Super Committee is being set up to fail and to reach an impasse.
Valuations Compelling
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 192 S&P 500 (38.4%) firms have dividend yields higher than the Friday yield on the 10 year T-note (2.25%), and almost two thirds (324, or 64.8%) yield more than the 5-year note (0.95%).
Keep in mind that 116 or 23.2% 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 dividend-paying stocks, 50% yield more than the 10-year and 83.4% yield more than the 5-year.
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 in the S&P 500 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. Almost one third of the dividend payers have increased their dividend by more than 10%.
New Recession Priced In
At the levels we reached by mid-week last week, it was 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. The market rallied strongly on Thursday and Friday when we got some data to suggest that that was not the case.
On Thursday we got the news that initial claims for unemployment insurance fell again, and are now 5,000 below the key psychological level of 400,000. That implies a pick-up in the pace of job creation in August.
Still not too great levels, and we have a very long way to go in bringing down unemployment to acceptable levels (and an even longer way to go in bringing down long-term unemployment), but it is not consistent with a near-term return to actual recession. That notion was further reinforced on Friday, when retail sales, and especially sales excluding autos, came in much better than expected. Not great on an absolute basis, but much better than expected and not consistent with a near term recession.
Despite that reassurance, 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.
Euro Trashed?
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 would be a very messy one, and will result in huge dislocations, and thus potentially cause economic collapse. For example, if someone in Italy owes $1 million euros, how many lira will that be when there is no longer a euro to pay back?
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 (hence the rumors about SoGen). If the European banking system goes down, ours will follow as night follows day. This is not a problem caused here, and is not the fault of Obama or 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.
No Options
The debt-ceiling deal means that the government is out of any potential options to deal with the aftermath of such a shock. In the second quarter the economy grew at only 1.3%, far below the consensus estimates of 1.7% growth.
The real shocker in the report were the downward revisions to past quarters. Most notably, the first quarter was revised down to just 0.4% from 1.9% and the fourth quarter was revised down to 2.3% from 3.1%. It also showed that the recession was FAR worse than previously reported, with a total decline in Real GDP of 5.1%, not the 4.2% we thought we had suffered. We need at least 2% growth to bring down unemployment.
Obama now says he wants to fight for jobs. 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 this week, 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.
My reading of the Fed statement was the Fed 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, but that the Fed Cavalry was not about to ride to the rescue of the settlers. The dissenters wanted the flexibility to ride out…to help foster the settlers’ slaughter.
Insurance Pays Off
I am still inherently optimistic. The U.S. has weathered many storms before, world wars, depressions, terrorist strikes and has always proved resilient. Stock market valuations remain compelling, and it is good to buy when things are cheap. Usually the end of the world does not happen.
There are plenty of companies that are in great shape and which will continue to grow and prosper. In the final analysis, the value of a company is based on what it will earn in the future, and what interest rate you have to discount those future earnings by.
Corporate earnings are still very strong and interest rates are very low. With the exception of the darkest days of late 2008-early 2009, the 12-month forward P/E ratio is at its lowest level in decades.
Still, these are perilous times on a macro level. I first suggested taking out insurance against a debt-ceiling fiasco in the June 30th edition of Earnings Trends. Then the 120 September SPY puts (my suggested vehicle, but just an example) were trading for $0.89. Now they are going for $5.75. Last week I suggested selling off half of those, and selling off the other half if the S&P were to hit 1100. You almost got a brief chance to close out completely on Wednesday, but not quite.
Given the volatility on Monday it is hard to say where you would have gotten out of the first half of the position on Monday, but you would have at least gotten $5.75. At this point I would say, still hold out for 1100 on the S&P until Labor Day. If we get to Labor Day and still have not hit 1100, go ahead and close out the position then.
Bullish on Balance
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 12.16x 2011, and 10.96x 2012 earnings. Put in terms of earnings yields, we are looking at 8.22% and 8.96%, while T-notes are only at 2.25%.
The old “Fed Model” suggested that the forward earnings yield (call it 8.70%) should be in line with the 10 year note. On that basis, stocks are wildly undervalued. 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. Between here and there could be a very bumpy ride though.
The direct implications of the S&P downgrade are overblown, but the other problems we face are not. I would not try to be a hero in here, just work yourself back into the market and buy good solid dividend paying firms with low P/Es. I suspect that if you buy a basket of firms yielding 3% or so that have been able to grow their dividends over the last five years at 10% or more you will be very happy you did five years from now.
I have no idea if you will be happy five days from now, or even five weeks from now. I suspect that the market will be higher than it is today five months from now, but not spectacularly so.
APPLE INC (AAPL): Free Stock Analysis Report
BANK OF AMER CP (BAC): Free Stock Analysis Report
WAL-MART STORES (WMT): Free Stock Analysis Report
Get all Zacks Research Reports and be alerted to fast-breaking buy and sell opportunities every trading day.
Be the first to comment