The fourth quarter earnings season is over, and now the focus turns to the first quarter. We already have 23 (4.6%) first quarter S&P 500 reports in.
The fourth quarter earnings season was a strong one, with total net income for those firms rising 30.7% over a year ago. The median surprise of 3.61% was also fairly strong, although the ratio of positive-to-negative surprises is only somewhat above normal at 3.14.
While it’s far too early to draw any conclusions, it looks like we are off to a good start on the first quarter, with reported net income growth of 24.9%, down just slightly from the 25.5% growth those same 23 firms reported in the fourth quarter. That, however, is not expected to last. The consensus is looking for a dramatic slowdown in growth for the remaining firms, with total net income rising just 7.71%.
Financial firms setting aside much less than a year ago for bed debts were a big part of the earnings story for the fourth quarter, and a big part of the deceleration in year-over-year growth has to do with a much higher base, particularly in the Financials in the first quarter of 2010 than in the fourth quarter of 2009. If the Financial sector is excluded, total net income rose 19.8% from a year ago in the fourth quarter, and in the first quarter it is expected to slow to 9.3%.
Growth to Reach Double Digits Again
Given the trend of positive earnings surprises, I would be shocked if the actual growth rate is that low. It is almost certain to be in the double-digits again. Revenue growth in the fourth quarter was healthy at 8.28%, but down from the 8.12% growth in the third quarter. Looking ahead to the first quarter, though, those firms yet to report are expected to post year-over-year revenue growth of just 4.14%.
Financials are the key reason for the slowdown in revenue growth; if they are excluded, reported revenue growth is expected to be 9.08%. Tougher year-over-year comparisons are a big part of the story.
Net Margin Expansion
Net margin expansion has been a driver of earnings growth, but that expansion is slowing down, particularly if one excludes the Financials. Overall, net margins are expected to come in at 9.03% in the first quarter, up from 8.73% a year ago, and from 8,92% in the fourth quarter. However, excluding the Financials, net margins are expected to only creep up to 8.29% from 8.27% a year ago, and down from 8.81% in the fourth quarter.
Among the handful of firms that have already reported for the first quarter, overall net margins are 7.18%, up sharply from 6.30% a year ago and from 7.07% in the fourth quarter. Strip away the Financials that have already reported and the picture is very different, rising to just 6.86% from 6.54% a year ago and even with what was reported in the fourth quarter.
Do not make too much of the level of reported net margins being significantly lower-than-the expected net margins. That is due to the reporting firms being very overweighted towards retailers (many have February fiscal period ends) which tend to be lower margin businesses.
On an annual basis, net margins continue to march northward. In 2008, overall net margins were just 5.88%, rising to 6.39% in 2009. They hit 8.59% in 2010 and are expected to continue climbing to 9.59% in 2011 and 10.31% 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 7.09% in 2009, but have started a robust recovery and rose to 8.24% in 2010. They are expected to rise to 8.84% in 2011 and 9.37% in 2012.
Growth and Health Forecast
The expectations for the full year are very healthy, with total net income for 2010 rising to $791.9 billion in 2010, up from $545.1 billion in 2009. In 2011, the total net income for the S&P 500 should be $909.1 billion, or increases of 45.2% and 14.8%, respectively. The expectation is for 2012 to have total net income passing the $1 Trillion mark to 1.034 Trillion. That will also put the “EPS” for the S&P 500 over the $100 “per share” level for the first time at $108.50. That is up from $57.22 for 2009, $83.07 for 2010 and $95.38 for 2011.
In an environment where the 10-year T-note is yielding 3.45%, a P/E of 16.0 based on 2010 and 13.9x based on 2011 earnings looks attractive. The P/E based on 2012 earnings is 12.2x.
With almost three 2011 estimates being raised for every two being cut (revisions ratio of 1.45), one has to feel confident that the current expectations for 2011 will be hit, and more likely exceeded. Analysts are raising their 2012 projections at an even higher rate, with a revisions ratio of 1.73.
While a lot can happen between now and the time the 2012 earnings are all in, upward estimate momentum means that the current 2012 earnings are more likely to be exceeded than for them to fall short. This provides a strong fundamental backing for the market to continue to move higher. The we are in the third year of the presidential cycle (almost always the best of the four, and by a big margin). We have a Democrat in the White House, which has historically meant good things for the stock market, with an average annualized return over the last 50 years more than triple that when the GOP holds the Oval Office. Few, if any, binomial variables have as much statistical significance.
Not All Smooth Sailing
That does not mean that all is smooth sailing ahead. We managed to avoid a government shutdown, but the reprieve only lasts until the end of this week. A government shutdown would not be good for either the market or the economy. On the other hand, the big spending cuts being demanded by the House would also be bad for the economy.
Though the economy does seem to have made a slow turn towards recovery, it is still tenuous. Even if we avoid a government shutdown, the House spending cuts of $61 billion would exert a very significant drag on the economy, as will the cuts that are happening on the State and Local levels. Mark Zandi, of Moody’s Economics, and a top economic advisor to the McCain campaign has estimated that the spending cuts could result in as many as 700,000 fewer jobs being created in 2011 and 2012, combined. The compromise level of $33 billion in cuts that is currently under discussion would still do significant damage to the recovery, although not as much as cutting $61 billion.
The impact will probably be about 1% slower GDP growth from the full $61 billion being cut, and about half of that based on the “compromise levels,” than if the cuts had not happened. The lower growth will result in lower tax collections, so the impact on the budget deficit will be much less than the amount advertised.
Jobs Environment Improving
Job creation remains sluggish, but is starting to show signs of picking up. We created 230,000 jobs in the private sector in March, down from 240,000 in February, but that is after a big upward revision to the February numbers.
However, State and Local governments laid off a total of 15,000 people for the month, on top of 46,000 pink slips the month before. Those jobs count just like private sector jobs, and are a major headwind to bringing down the total number of unemployed. The idea that one can reduce unemployment by cutting jobs is positively Orwellian, and it is hard to believe the advocates of doing so are taken seriously.
The household survey has been much more upbeat, showing growth of 291,000 jobs in March, on top of 250,000 gained the month before. The unemployment rate fell to 8.8%, and it was as high as 9.8% as recently as November.
The international situation clearly has the potential to abort the recovery as well. The disaster in Japan will clearly slow its economy dramatically in the first quarter, although much of that growth will be made up later in the year as the reconstruction process gets under way. Many U.S.-made products have parts which are made in Japan and that is likely to disrupt production here.
The turmoil in the Middle East is not going away, and that is likely to keep oil prices both high and volatile. High oil prices will also act as a depressing force on the economy.