Earnings Strong So Far

The 4th quarter earnings season is now in full swing. It is still on the early side, with just 81, or 16.2%, of the S&P 500 reports in. However, history does suggest that by the time you have about 15% of the sample, you can have a pretty good feel for how the rest of the earning season will go.

The early reports are encouraging, with total net income for those firms rising a stunning 63.3% over a year ago. The early median surprise of 6.56% is also quite strong, although the ratio of positive to negative surprises is only somewhat above normal at just 3.69. However, those numbers are always extremely volatile in the early going.

Most of the focus should be on the expectations for those who have yet to report. It seems pretty clear that we got a big batch of the highest growers out of the way early. The expectations are that the remaining 419 of the S&P 500 firms will post total net income that is just 12.26% than a year ago. That is a slowdown from the year over year growth of the third quarter (20.2%).

The firms that have reported are somewhat bigger/more profitable than those that have yet to report, on average. If all the remaining firms were to report exactly as expected, then 27.4% of the total earnings expected for the quarter are in. The implied total growth is 23.4%. Given that positive earnings surprises almost always outnumber disappointments, one does not need an overly active imagination to envision that growth will be over to 25% again when all is said and done for the quarter.

Revenue Growth Expected to Fall

Revenue growth, though, is expected to slow down significantly, actually falling 0.33% from positive growth of 9.01% in the third quarter. On the other hand, revenue growth among those companies that have reported is very healthy at 7.54%.

The financials are a big part of the overall revenue growth slowdown, but not the entire story. They are also somewhat over-represented in the early going, responsible for 34.8% of all the net income reported so far. Excluding them, revenue growth is expected to slow to 2.50% year over year from 8.85%.

Tougher year-over-year comparisons are a bigger part of the story. However, as I mentioned above, revenue surprises have been quite strong so far, with a median revenue surprise of 1.50%.

Net Margin Expansion

Thus the stellar earnings growth is mostly due to the continued expansion of net margins. Much of the year-over-year margin expansion is due to the financials, where the whole concept of revenues is a bit different from most companies, and thus the concept of net margins is also a bit different. Much of the earnings growth in the financials has come from firms setting aside less for bad debts than they did last year. One should be a bit on the doubtful side about the quality of those earnings, particularly in the absence of mark-to-market accounting.

Among those that have reported, net margins are 11.97%, or 11.56% if one excludes the financials, up from 7.88% (9.93% excluding financials) a year ago, and 11.71% (10.69% excluding financials) in the third quarter. The expected net margin for the remainder is 8.12% (7.72% excluding financials) up from 7.21% (7.56% ex-financials) last year.

Net margins continue to march northward on a yearly basis. In 2008, overall net margins were just 5.88%, rising to 6.42% in 2009. They are expected to hit 8.80% in 2010 and continue climbing to 9.68% in 2011 and 10.19% 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 7.13% in 2009, but have started a robust recovery and are expected to be 8.25% in 2010, 8.93% in 2011 and 9.36% in 2012.

Full-Year Expectations and Beyond

The expectations for the full year are very healthy, with total net income for 2010 expected to rise to $782.6 billion in 2010, up from $544.3 billion in 2009. In 2011, the total net income for the S&P 500 should be $907.0 billion, or increases of 43.2% and 15.9%, respectively.

The early expectation is for 2012 to have total net income of just over the $1 Trillion mark. That will also put the “EPS” for the S&P 500 over the $100 “per share” level for the first time at $105.81. That is up from $57.67 for 2009, $82.60 for 2010, and $95.54 for 2011. In an environment where the 10-year T-note is yielding just 3.45%, a P/E of 15.5x based on 2010 and 13.4x based on 2011 earnings looks attractive.

With almost two 2011 estimates being raised for each one being cut (revisions ratio of 1.91), one has to feel confident that the current expectations for 2011 will be hit, and more likely exceeded. This provides a strong fundamental backing for the market to continue to move higher.

Historical/Political Factors

The bullish argument is further boosted by such historical factors such as being in the third year of the presidential cycle (almost always the best of the four) and having a Democrat in the White House and the GOP at least partially in charge at the other end of Pennsylvania Ave. While there is not a huge sample size of years with that political alignment, those that exist were very good ones for the stock market.

On the other hand, there is a very real prospect of total political gridlock, which would greatly raise uncertainty about governmental policy and the strength of the economy that could undermine confidence. As Shakespeare said: “Beware the ides of March.” That is approximately when the U.S. will hit its current debt ceiling.

If the debt ceiling is not raised, the U.S. government would go into at least a technical default on its debt, and the government would probably have to shut down. That is hardly something that will inspire confidence in the markets. And while it is inconceivable that a higher debt ceiling will not eventually be passed, it is an opportunity for major political theater, and there is a chance that there will be a delay between the debt ceiling being hit and when it gets raised.

The (Slow) Road to Recovery

The economy does seem to have made a slow turn towards recovery. However, job creation remains very sluggish. Most of the real growth in the economy has come from higher productivity, not more hours being worked. Those productivity gains are accruing to capital, not labor and are a major reason behind the strong earnings growth.

Still, companies are expected to continue growing their earnings nicely, and the 15.9% expected growth for 2011, if achieved, means that the total earnings for the S&P 500 should hit a new record by the middle of next year. The fact that analysts are, on balance, still raising estimates for 2011, increases the odds that that growth will be achieved.

Growth of 15.9% is not exactly awful. Even on the revenue side the expected growth in 2011 of 5.36%, or 6.09% if one excludes the financial sector, is still pretty solid. Clearly the analytical community is not expecting the economy to turn south again.

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