The first quarter earnings season is almost done. We now have 435 (87.0%) of the S&P 500 reports in. We have enough of a sample now to be pretty sure this will be a good earnings season.
So far, we have income growth of 19.9%. While that is down from the extremely strong 31.4% those same 435 firms posted in the fourth quarter, it is still a very strong growth rate. Almost all of the growth slowdown is from a failure of the Financial sector to repeat the massive growth they posted in the fourth quarter.
Tougher Comps for Finance Companies
It’s not that the Financials are having a bad quarter, but they do face much tougher comps this time around. If we back out the Financials, total net income is up 20.9% so far, actually up from the 19.0% those firms reported in the fourth quarter.
Looking ahead to the second quarter, growth is expected to continue to slow, but remain in the double digits at 11.7%. Back out the Financials and growth is expected to be 13.1%.
Revenue growth is also very strong at 9.49%, up from the 7.78% growth they posted in the fourth quarter. Financials are a major drag on revenue growth; if they are excluded, reported revenue growth is 12.14%, up from the 9.26% growth posted last quarter. Revenue growth is also expected to slow in the fourth quarter, falling to 6.53% year over year for the S&P 500 as a whole and 9.33% if the Financials are excluded.
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 10.02%, up sharply from 9.15% a year ago and from 9.32% in the fourth quarter. Strip away the financials and the picture is somewhat different, rising to 9.43% from 8.74% a year ago and from the 9.18% reported in the fourth quarter.
Cyclicals Drive the Market
The more cyclical parts of the economy will be leading the growth charge this quarter. The highest growth comes from the Industrials sector, with growth of 82.5%. Three other sectors are posting growth over 40%: Autos (46.9%), Materials (45.6%) and Energy (40.5%).
Construction is without a doubt the weakest of the sectors, with total net income plunging 34.3% from a year ago. The only other sector will declining net income are the Utilities, down 1.5% from a year ago. Anemic, but positive growth of 3.7% for is seen for Staples.
Net Margin Expansion
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 9.49% in 2011 and 10.18% 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 7.08% in 2009, but have started a robust recovery and rose to 8.22% in 2010. They are expected to rise to 8.84% in 2011 and 9.32% in 2012.
Full Year Expectations Healthy
The expectations for the full year are very healthy, with total net income for 2010 rising to $792.0 billion in 2010, up from $544.7 billion in 2009. In 2011, the total net income for the S&P 500 should be $922.2 billion, or increases of 45.4% and 16.4%, respectively. The expectation is for 2012 to have total net income passing the $1 Trillion mark to $1.047 Trillion.
That will also put the “EPS” for the S&P 500 over the $100 “per share” level for the first time at $109.79. That is up from $57.13 for 2009, $83.08 for 2010 and $96.75 for 2011. In an environment where the 10-year T-note is yielding 3.15%, a P/E of 16.2x based on 2010 and 13.8x based on 2011 earnings looks attractive. The P/E based on 2012 earnings is 12.2x.
The analysts have responded to the better-than-expected earnings for the first quarter by raising their estimates for 2011. That’s not particularly shocking, as the first quarter is after all, part of 2011, so if they did not increase in response to a positive surprise, they would implicitly be cutting their estimates for the remaining three quarters of the year.
Still, the flood of estimate increases is impressive, with the revisions ratio climbing to 1.96 from 1.84. With total estimate revisions activity soaring, that increase is overwhelmingly being driven by new estimate increases, not from old estimate cuts falling out of the four-week moving totals. Changes in the revisions ratios are more significant when activity is rising than when it is falling (since it reflects new information).
The estimate increases are widespread, with the ratio of firms with rising mean estimates to firms with falling estimates standing at 1.96. There is no “mechanical” reason for the estimates for 2012 to be rising, yet those are even stronger than the ones for 2011. The 2012 revisions ratio is now at 2.14, meaning that upwards estimate revisions are outpacing cuts by more than 2:1 for next year. The ratio of rising-to-falling mean estimates stands at 1.96. Those are extremely bullish readings.
This provides a strong fundamental backing for the market to continue to move higher. Yes, the market did not seem to have much of a reaction to the positive news coming out of Abbottabad last week, but then again, I cannot think of a single company that will earn a single extra dollar as a result of Hell getting just a little bit more crowded.
Bumps in the Road
That does not mean that all is smooth sailing ahead. We managed to avoid a government shutdown, but only at the cost of large spending cuts that will slow the economy. The drama is not over — that was just the end of the first act. The fight over raising the debt ceiling is going to be underway soon.
If it looks like the debt ceiling will not be raised, watch out. The Government of the United States defaulting on its debt is likely to have a somewhat larger impact on the markets and the economy than the impact of Lehman Brothers defaulting on its debts. However, when push comes to shove, I find it hard to believe that even Congress could be so stupid as to let that happen.
We are already feeling the impact from lower government spending. First quarter GDP growth came in at just 1.8%, down from 3.1% in the fourth quarter. Total government spending was a drag of 1.09 points, more than the 0.34 point drag in the fourth quarter. In other words, 0.75 of the total 130 point growth slowdown (57.8%) was due to increased austerity in Government spending.
In the third quarter, government spending contributed 0.79 points of the 2.60% total growth. The lower growth will result in lower tax collections, so the impact on the budget deficit will be much less than the amount advertised. Job creation remains sluggish, but had been starting to show signs of picking up.
We created 268,000 jobs in the private sector in April, up from 231,000 in March, and 260,000 in February, but that is after a big upward revision to the February numbers. However, governments laid off a total of 24,000 people for the month, on top of 10,000 pink slips the month before. How is it that one can reduce unemployment by cutting jobs?
Jobless Claims Starting to Trend Up
Recently though, the trend in Initial Claims for Unemployment has taken a nasty turn for the worse, with the four-week moving average moving back above the 400,000 level for the first time since January. Initial claims rose by 43,000 to 474,000 last week. Those numbers were not reflected in the April jobs report, but they are not a good omen for the May report.
The unemployment rate bounced back up to 9.0%. Given that the unemployment rate has been higher than that in just 6.17% of the months since 1960, one might expect that bringing down unemployment would be top of the agenda at both the Fed and on Capitol Hill. However, at Bernanke’s recent press conference, the focus was mostly on inflation — even though headline inflation has been higher than the current level of 2.7% in 65.4% of the months since 1960, and core inflation has been higher in 95.5% of the months. This fear of phantom inflation is keeping further monetary easing off the table for bringing down unemployment.
International Concerns Remain
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 underway. Many U.S.-made products have parts which are made in Japan and that is likely to disrupt production here. Still, there appeared to be no impact on Industrial Production in March as manufacturing output climbed 0.7%.
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.
The Debt Crisis in Europe is not going away either, with Portugal now also getting bailed out, even as the ECB makes life tougher on the PIIGS by raising rates.
Housing Still Dire
The housing situation is still dire, even if new home sales were a bit better than expected in March at 300,000. That is still one of the lowest levels on record, and less than half of a “normal” new home sales pace. Prices of existing homes continue to fall, and with them the housing equity wealth that makes up the bulk of the wealth of the middle class.
On the plus side, the dollar has been weak, and that should improve the trade deficit, and that will be a significant positive for the economy. The foreign operations of U.S. companies will be much more profitable when the results are measured in dollars. Inflation, other than in food and energy, is well contained, up only 0.1% in March and 1.2% year over year. That should let the Fed stay on Easy Street as far as monetary policy is concerned.
Overall: Staying Positive
On balance I remain bullish, and I think we will end the year with the S&P 500 north of 1400, but that does not mean we will necessarily have a smooth ride between here and there. Strong earnings are trumping a dicey international situation and the drama in DC. However, be prepared to move to the exits (or perhaps have some put protection in place) if it looks like the debt ceiling will not be raised.