|Expectations for 2012 Begin Falling (all the stats) |
Dirk Van Dijk, On Tuesday August 23, 2011, 1:00 am EDT
- Almost done with earnings season, with 486 or 97.2% of S&P 500 second quarter results in. Total earnings growth low at 12.0%, but mostly due to one stock (BAC). Ex-Financials growth is 19.8% year over year. Total revenue growth 10.9%, 11.3% ex-Financials. Median earnings surprise 3.13% and median sales surprise 1.81%. Remaining firms (14) expected to grow 10.8%, but only 1.1% of expected total earnings.
- If remaining firms all report in line, we have 98.9% of earnings in. Final growth to be 12.0%, 19.8% ex-Financials. At start of earnings season 9.65% growth expected, 12.18% ex-Financials.
- Earnings beats top misses by 3.49 ratio, sales beats top misses by 2.49 ratio; 69.8% of all firms report positive earnings surprise, 70.6% beat on revenues. Growing earnings firms outpace declining earnings by a 3.13 ratio, Revenues at a 5.15 growth ratio.
- Full-year total earnings for the S&P 500 jumps 45.5% in 2010, expected to rise 15.9% further in 2011. Growth to continue in 2012 with total net income expected to rise 9.5%. Financials major earnings driver in 2010. Excluding Financials, growth was 27.7% in 2010, and expected to be 18.8% in 2011 and 8.9% in 2012. One month ago, growth of 15.7% for 2011 and 13.9% for 2012 expected. Ex-Financials, 18.6% and 10.3%, respectively.
- Total revenues for the S&P 500 rise 7.88% in 2010, expected to be up 6.67% in 2011, and 6.28% in 2012. Excluding Financials, revenues up 9.16% in 2010, expected to rise 11.08% in 2011 and 5.65% in 2012.
- Annual Net Margins marching higher, from 5.88% in 2008 to 6.40% in 2009 to 8.64% for 2010, 9.34% expected for 2011 and 9.67% in 2012. Margin expansion a major source of earnings growth. Net margins ex-Financials 7.79% in 2008, 7.07% in 2009, 8.27% for 2010, 8.84% expected in 2011 and 9.12% in 2012.
- Revisions ratio for full S&P 500 at 1.53 for 2011 (bullish), at 1.18 for 2012 (neutral). Ratio of firms with rising to falling mean estimates at 1.33 for 2011, 1.26 for 2012, bullish readings. Total revisions activity near its peak, but will fall rapidly over next month.
- S&P 500 earned $546.5 billion in 2009, rising to $795.0 billion in 2010, expected to climb to $921.3 billion in 2011. In 2012, the 500 are collectively expected to earn $1.008 Trillion. On 7/22, 2012 expectations were $40 billion higher, with Financials responsible for $30 billion of the decline.
- S&P 500 earned $56.77 in 2009: $82.61 in 2010 and $95.74 in 2011 expected, bottom-up. For 2012, $104.78 expected. Puts P/Es at 13.7x for 2010, and 11.8x for 2011 and 10.8x for 2012, very attractive relative to 10 year T-note rate of 2.25%. Top-down estimates: $96.26 for 2011 and $105.44 for 2012.
The Earnings Picture
Second-quarter earnings season is almost over with 486 or 97.2% of the reports in. With the exception of a handful of financials, most notably Bank of America (NYSE: BAC - News), 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 12.0%, way off the 17.6% pace those same 486 firms posted in the first quarter. However, if you exclude the Financial sector, growth is 19.8%, actually up slightly from the 19.7% pace of the first quarter. The 97.2% 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 98.9% 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 very strong, with 10.94% year-over-year growth for the 486, actually up from growth of 8.73% in the first quarter. The top line results are even more impressive if the Financials are excluded, rising to 11.25% 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 1.81% and a 2.49 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 (14) still to report, the rate of growth is expected to be well below what we have seen already, with growth of 10.8%. With nine sectors now done, and many more sectors with only one or two firms left to go, use caution in interpreting the “expected tables at the sector level. Revenue growth for the remaining firms is also expected to slow, rising 7.87% among those yet to report, down from 9.05% 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 486 that have reported have net margins of 9.20%, up from 9.11% a year ago. However, that is due to the Financials, especially BAC. Excluding Financials, next margins have come in at 8.55%, up from 7.94% 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 9.34% in 2011 and 9.67% 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 9.12% 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 $921.3 billion, marking increases of 45.5% and 15.9%, respectively. The expectation is for 2012 to have total net income passing the $1 Trillion mark to $1.008 Trillion, for growth of 9.5%. 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 $56.77 for 2009, $82.61 for 2010, and $95.74 for 2011.
In an environment where the 10 year T-note is yielding 2.06%, a P/E of 13.7x based on 2010 and 11.8x based on 2011 earnings looks attractive. The P/E based on 2012 earnings is 10.8x. However, the 2012 expectations have fallen significantly in recent weeks as the economic outlook has softened. Relative to a month ago, expected total earnings for 2012 are down by $40 billion, with $30 billion of that decline coming from the Financial sector. This is an important thing to watch going forward.
Estimate revisions activity is near 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 stands at 1.53 (up from 1.62 last week) for 2011 and 1.18 (down from 1.4 last week) for 2012.
The Bigger Picture
It is an open question right now if we are going to fall back into recession later this year or early next year. I still think the most likely case is that we muddle through with slow but positive growth, but the odds of a recession seem to be growing. The economic news this week was not that good. We started out the week learning that the American Institute of Architects billing index fell again to 45.1 from 46.3, its lowest level since February 2010 and the fifth drop in a row. It is a Magic 50 index where any reading below 50 means contraction. Since non single family home construction almost always requires an architect, this pretty much insures that we will be seeing a renewed downturn in Commercial construction later this year and into 2012.
Existing Home Sales came in well below expectations and were down 3.5% from June. They were up year over year by 21.0% but that was due to an exceptionally easy comps from last year (after the end of the home buying tax credit). Months of supply rose to 9.4 months from 9.2. A healthy market has 6 months worth of supply and four months was the norm during the bubble. This pretty much means that home prices are going to continue to fall (oh and the median price of an existing homes was down 4.4% year over year). With existing home prices still falling, it is very hard to see any near term rebound in New Home Construction, which is normally the locomotive that pulls us out of recessions.
Inflation came in a bit hotter than expected at 0.5% on headline, although the core was in line with expectations at 0.2%. With oil prices falling again, we should see headline below core again next month. Still it will add some ammo to the argument of those who are against the Fed taking any more aggressive actions to help the economy. Within the core, housing costs were a big upward driver, with both Rent and Owners Equivalent Rent rising 0.3%, the fastest in a very long time. Together they make up 31% of the overall CPI. Also the Philly Fed index plunged to a -30.7, an exceptionally poor reading, down from a positive 3.2 and one that in the past has always signaled recession. One “sure fire recession signal that we have not seen yet, nor are we likely to given the current Fed policy is an inverted yield curve (short rates higher than long rates). On the other hand the index of Leading Economic Indicators actually increased to 0.5% from 0.3%. Thus overall there is not a slam dunk case either way as to if we are headed into a recession.
Initial claims for unemployment insurance, a bright spot the week before, disappointed a bit and rose back over the key 400,000 level to 408,000. That is a level that is consistent with job growth, but not enough to bring down the unemployment rate. The August jobs report will probably look a lot like the July jobs report, with about 150,000 or so private sector jobs added offset by the loss of about 40,000 government jobs and the unemployment rate staying about 9.1%.
The humiliation of Standard & Poor’s for its recent downgrade of T-notes continued. The yield on the 10 year actually briefly fell below 2% for the first time since before WWII, before ending the week at 2.06%. When a bond gets downgraded, it is supposed to see its yield rise, not fall off a cliff. 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 away from 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. It was the first time in history that the 10 year real interest rate had fallen to negative territory. In other words, people are actually paying in real terms for the privilege of lending to the U.S. Treasury. 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.
In time 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 to do the job. 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 so they would have to sell dollars and buy either Yen or Euros. That would weaken the dollar and strengthen those currencies. That would make 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.
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.
The current debate has it all wrong, or at least is putting the cart before the horse. If we can bring down unemployment, the deficit will follow. The reverse is decidedly not true. Current efforts to bring down the deficit are making unemployment worse, not better, and will in the end undermine the objective of bringing down the deficit. A Trillion dollars of Spending Cuts is not going to lead to a Trillion dollars of deficit reduction. Perhaps $500 billion worth if we are lucky.
That is particularly true if the cuts are front end loaded and happen while the economy is operating well below its potential. Spending cuts when the economy is humming along will not have such a terrible effect on the overall economy. Tax revenues rise and fall by more than the amount of economic growth. There is a lot of spending that kicks in automatically as the economy falls. Food Stamps would be one example of that. When the economy is operating near its potential, then government spending can crowd out productive private investment. When the economy is operating far below its potential, as it is today, then the only thing that government spending crowds out is idleness and unemployment.
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. Of course, that would require 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 NG is well established. We already have a good distribution system for natural gas, but not for refueling cars with it.
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 235 S&P 500 (47.0%) firms have dividend yields higher than the Friday yield on the 10 year t-note (2.06%), and over two thirds (339, or 67.8%) yield more than the five year note (0.95%). Heck, 1.05 or 21.0% yield more than even the 30 year bond (3.39%). 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 (NasdaqGS: AAPL - News) with its $76 billion cash hoard could easily pay a dividend if they wanted to. Of the dividend paying stocks, 61.2% yield more than the 10 year and 88.3% yield more than the five year. Those sorts of numbers have not been seen since the early 1950s. 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 1930s. Almost one third of the dividend payers have increased their dividend by more than 10%.
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. 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. The French President Sarkozy and the German Chancellor Merkel got together and threw cold water on the idea of creating Eurobonds, or bonds that were backed by all of Europe. Instead they proposed the creation of a council of all the heads of government for the 17 countries using the Euro that would set national economic fiscal policies throughout Europe. This would probably require changes to the Constitutions of every one of those countries. I just don’t see that happening.
Ultimately, one of two things is going to have to happen. Either fiscal policy will have to be consolidated in Europe as a whole (what Merkel and Sarkozy were suggesting), 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 Liras is going to 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. 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, 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.
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 (we will get the second look at second quarter growth on Friday). 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 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. 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 big event of the week will be Bernanke’s speech in Jackson Hole Wyoming on Friday. Last year he telegraphed QE2 there. Given the dissention on the Fed board, I don’t think we will see QE3. There are some steps that could be done however. First and foremost of these would be to stop paying banks 0.25% on their excess reserves. That effectively rewards them for not lending. I would cut that to zero, or possibly even consider making the rate slightly negative.
Stay Invested but Buy Insurance
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 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. On Friday they are going for $9.05. Two weeks ago, I suggested selling off half of those, and selling off the other half if the S&P were to hit 1100. You have not been stopped out yet, but have come close a few times over the last two weeks. At this point I would say 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.
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 12.8x 2011, and 10.8x 2012 earnings. Put in terms of earnings yields, we are looking at 8.45% and 9.25%, while T-notes are only at 2.25%. The old “Fed Model suggested that the forward earnings yield (call it 8.85%) 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. However, even though we are seeing more analysts raise their estimates for 2012 than cut them, the overall expected total net income for 2012 has started to fall off by a total of about $40 billion over the last month. Of that $30 billion has come from the Financial sector. While that still implies growth of 9.45% over the expected 2011 levels, it is down from growth of 13.5% a month ago. That is a trend that bears watching very closely.
Long-term investors should start to take advantage of the current valuations. However I would not be shooting for 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...
Scorecard & Earnings Surprise
- Another great earnings season. So far, 459 (91.8%) reports in. Total Growth looks low at 12.18% but that is entirely due to a handful of Financials). We have a 3.49 surprise ratio, and 3.13% median surprise. Positive surprises for 69.9% of all firms reporting.
- Positive year-over-year growth for 349, falling EPS for 107 firms, a 3.26 ratio; 76.0% of all firms reporting have higher EPS than last year.
- Nine sectors done, most others down to one or two left to go, but should not have much effect on final numbers.
- Autos, Discretionary and Tech lead in surprise; Transports, Industrials lag.