The Earnings Picture
Second quarter earnings season is effectively over with 492 or 98.4% 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 has been another great earnings season.
The year-over-year growth rate for the S&P 500 is 12.1%, way off the 17.6% pace those same 492 firms posted in the first quarter. However, it you exclude the Financial sector, growth is 19.7%, down only slightly from the 19.8% pace of the first quarter.
The 98.4% 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 99.7% of the total earnings in. 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 12.45% growth expected overall, and 12.2% 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 Impressive
Top-line results were also very strong, with 10.93% year-over-year growth for the 492, actually up from the 8.73% growth they posted in the first quarter. The top-line results are even more impressive if the Financials are excluded, rising to 11.24% from the 9.45% pace of the first quarter.
Top-line surprises have been almost as good as the bottom-line surprises, with a median surprise of 1.78% and a 2.50 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.
Looking ahead to the third quarter, year-over-year growth of 6.22% is expected for the full S&P 500, and 6.44% 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
Net margins have been one of the keys to earnings growth, but cracks in the story are starting to appear. The 492 that have reported have net margins of 9.22%, up from 9.13% a year ago. That, however, is due to the Financials, especially BAC. Excluding Financials, next margins have come in at 8.58%, up from 7.98% a year ago.
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 9.33% in 2011 and 10.12% 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 8.84% 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 $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 $921.3 billion, or increases of 45.5% and 15.8%, respectively. The expectation is for 2012 to have total net income passing the $1 Trillion mark to $1.054 Trillion, for growth of 14.5%.
That will also put the “EPS” for the S&P 500 over the $100 “per share” level for the first time at $110.30. That is up from $57.16 for 2009, $83.16 for 2010, and $96.28 for 2011. In an environment where the 10-year T-note is yielding 2.19%, a P/E of 13.9x based on 2010 and 12.0x based on 2011 earnings looks attractive. The P/E based on 2012 earnings is 10.5x.
Estimate revisions activity has passed 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, to slightly below 1.0 for both this year and next. It then rose sharply during the height of earnings season again, but now has stated to fall. The revisions ratios stand at 1.30 (down from 1.53 last week) for 2011 and 0.96 (down from 1.18 last week) for 2012.
Recap of Key Data and Events of the Week
Earthquakes, hurricanes — what’s next? Locusts, or maybe frogs? Yet despite all that, it was not too bad a week for the market. Yeah a bit of volatility, but a much better week than most that we have seen in recent weeks.
Two of the biggest stories were Steve Jobs giving up the CEO post at Apple (AAPL) and Warren Buffett investing $5 billion in Bank of America (BAC) preferred stock. Both were unexpected, at least as to the timing. Jobs will stay on as CEO, but it looks like due to health issues he will have a very limited role.
On a day to day basis I’m sure that Apple will do fine under its new CEO, Tim Cook. The big question is if the pace of innovation can keep up without Jobs around. Health issues are not new for Jobs, so they have had some time to prepare, and try to institutionalize the innovative culture there. Only time will tell if they succeeded.
Buffett’s investment in BAC looks very much like the ones he did with Goldman Sachs (GS) and General Electric (GE) in the depths of the 2008 meltdown. Both of those worked out pretty well for him and Berkshire Hathaway (BRK.B).
With earnings season over, those were the things that the market focused on, along with a smattering of mixed economic data, and of course the earthquake and hurricane. I don’t think the data really confirmed one way or another if a new recession is on its way.
New Home Sales
New Home Sales were weaker than expected, and June was revised down. We need a rebound in New Home Sales to really get the economy moving again. At least in every previous recession since WWII, residential investment has been the key part of the economy that gets everything moving again. On the other hand, with the lowest 15 months of new home sales in history being in the last 15 months, residential investment has shrunk to the point that it really can’t do much additional damage to the economy.
Eventually, the pressures of a rising population and additional household formation will allow residential investment to pick up. When that happens the overall economy will start doing much better, but it does not look like that is going to happen anytime soon.
Durable Goods Orders
We got better New Orders for Durable Goods last week. They came in much stronger than expected, rising 4.0%, well above the expected 1.9%, and June was revised up to being down just 1.3% from down 2.1%. Durable Goods is, however, a very volatile series, and most of the improvement came from the most volatile part of it, Transportation equipment, especially orders for civilian aircraft.
There was also strength in the other major part of transportation equipment, orders for cars and trucks. That mostly reflected easing of the supply chain constraints caused by the Japanese disaster. Excluding Transportation equipment, things were still better than expected, rising 0.7% rather than the expected drop of 0.4%. The June numbers were also revised up from a rise of 0.1% to a rise of 0.6%.
The durable goods number is strong evidence that we are not yet in a new recession. I would note however that the strength was narrowly based, and orders for things like Machinery and Computers were down. Thus it would be premature to sound the all clear signal.
GDP Revisions
We also got the second look at second quarter GDP. It was revised down to 1.0% from an already very anemic 1.3% from the first look. However, the quality of the growth was much better. More than all of the decline can be traced to inventories actually being drawn down in the second quarter, rather than being built up.
Inventory investment is very low quality growth, which tends to be reversed in subsequent quarters. Of a bit more concern were the downward revisions to net exports, which is much higher quality growth. Most of that came from our exports not being as strong as we had thought, but also some from higher imports.
Trade Deficit
I continue to insist that the Trade Deficit is a much bigger economic problem, particularly over the short- to medium-term, than is the Budget Deficit. Bringing the Trade Deficit under control, on the other hand, would bring down unemployment and thus the Budget Deficit.
That will really require us to do two things. First, see a much weaker dollar so our goods are cheaper abroad, and foreign goods are more expensive here. That, of course, though would require that other currencies get stronger, and no government right now really wants a strong currency. Even the Swiss have been intervening in the markets to weaken their currency.
The second thing would be to rapidly move to the use of Natural Gas as a transportation fuel. We have lots and lots of it here and it is cheap. The technology for running cars on nat gas is well established. We already have a good distribution system for natural gas, but not for refueling cars with it.
The downward revisions to inventory investment and net exports were partially offset by higher non-residential fixed investment and consumption, particularly of services. Non-residential fixed investment — particularly in equipment and software — is the highest quality part of growth, as it lays the foundation for further growth. Net-net, I would call the revisions just slightly negative to neutral.
Jobless Claims
Initial Claims for jobless benefits climbed again, to 417,000, dashing hopes that we might get down below the 400,000 level and stay there. That is the level that would indicate that the economy is producing enough jobs on balance to start to bring down the unemployment rate. Most of the increase though was due to the strike against Verizon (VZ) which is now on hiatus as talks continue.
Jackson Hole Speech
The most highly anticipated event of the week, Ben Bernanke’s speech in Jackson Hole, turned out to be a big nothing. He really didn’t tell us anything we didn’t already know, other than that the September Federal Reserve Board meeting will be two days rather than just one. Yes, he acknowledged that the economy has been softer than they had been forecasting, but he did not announce any policy steps that the Fed was going to take to try to get things moving again.
Basically he said, “We have done our part, but now it is up to Congress and the Administration.” He called for both a long-term plan to bring down the deficit, but cautioned strongly (well, at least as strongly as the reserved language of a Central Banker will allow) against near-term austerity. In this I am in total agreement with him, and wish he had used still stronger language to make his point.
While the door is not closed on further monetary stimulus, it will not be coming right away. What we really need is more fiscal stimulus. Unfortunately, that is not likely to happen either. Indeed, we will probably be lucky if the House does not demand that even any disaster-related spending due to the hurricane be offset dollar for dollar with further cuts to other spending for this year and next.
The Answer This Week?
The coming week is going to be very heavy in terms of economic data releases. Hopefully they will help answer the one question that the market most wants to know the answer to: Are we headed back into a recession or not? At this point, I still think the odds are against it, but the odds have been rising, probably to about 30 to 40%.
Meanwhile, the odds of a robust near-term recovery that will bring down unemployment have shrunk to being a very long shot. Second-half growth looks to be much more like what we saw in the first half than the growth of almost 4% that the Fed was looking for just a few short months ago.
The most important economic report is going to be the unemployment report on Friday. I’m a bit more hopeful than the consensus for that report. I think August is going to look a lot like July, where we got a total of 117,000 net new jobs, including 157,000 on the private side. The consensus is looking for 111,000 on the private side in August, and a total of 75,000 jobs, as State and Local governments continue to hand out massive numbers of pink slips.
As the graph below shows, State and Local governments normally increase employment coming out of recessions. Not only that, most of the time they accelerate their hiring. That has not been true this time. While private-sector employment has started to slow down on a year-over-year basis, it is actually running higher now than it did at this point after the last two downturns.
State and local governments are major employers, together accounting for 14.6% of all the jobs in the country. That is more than the combined employment from Manufacturing, Construction and Mining (13.8%).
A big part of the ARRA was aid to the State and Local Governments to try to prevent those layoffs, and it helped minimize them for a while, but now the money has dried up, and the layoffs at the State and Local level are likely to get worse, not better, going forward. That is going to be a substantial headwind moving forward in trying to bring down the total number of unemployed.
Stocks Look Cheap
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, 227 S&P 500 (45.4%) firms have dividend yields higher than the Friday yield on the 10-year T-note (2.19%), and almost two thirds (327, or 65.4%) yield more than the five-year note (0.94%). Heck, 86 or 17.2% yield more than even the 30-year bond (3.39%).
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, 53.9% yield more than the 10-year and 84.7% 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 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.
Europe’s Problems Remain
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. Still, the new head of the IMF recently warned:
“[European] banks need urgent recapitalization. They must be strong enough to withstand the risks of sovereigns and weak growth. This is key to cutting the chains of contagion. If it is not addressed, we could easily see the further spread of economic weakness to core countries, or even a debilitating liquidity crisis. The most efficient solution would be mandatory substantial recapitalization—seeking private resources first, but using public funds if necessary. One option would be to mobilize EFSF or other European-wide funding to recapitalize banks directly, which would avoid placing even greater burdens on vulnerable sovereigns.” In effect, this is an argument for a Euro-TARP.
Fiscal policy may have to be consolidated in Europe as a whole (what Merkel and Sarkozy were suggesting last week), 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 in Europe, 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 European Central Bank (ECB), and that is largely controlled by the Germans. The process of unscrambling the Euro egg and going back to Drachmas and Liras would be a very messy one, and would result in huge dislocations, and thus potentially cause economic collapse.
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, 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.
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. Unfortunately, the data only goes back to 1980 and is just through the end of the first quarter. All indications though are that is continued to decline in the second quarter.
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.
What the Fed Said
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 votes against. 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 the slaughter of the settlers.
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 8.31% and 9.51%, while T-notes are only at 2.19%.
The old “Fed Model” suggested that the forward earnings yield (call it 8.85%) 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.
APPLE INC (AAPL): Free Stock Analysis Report
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