The 4th quarter earnings season is in full swing. We now have 206 or 41.2% of the S&P 500 reports in. However, the early reporting firms tend to be a bit bigger and more profitable than the stragglers, and those 206 firms actually represent 56.3% of the total expected net income.
That, of course, presupposes that all the remaining firms report exactly as expected, which is unlikely. But it shouldn’t be too far off — those 206 firms also represented 54.0% of all the net income a year ago.
The reports are encouraging, with total net income for those firms rising 31.2% over a year ago. The early median surprise of 4.28% is also fairly strong, although the ratio of positive-to-negative surprises is only somewhat above normal at just 3.73. Total net income of the reporting firms is 31.24% higher than a year ago, a slight slowdown from the 34.45% growth those same firms posted in the third quarter.
Big Earners Report First
It seems the higher growers reported early. The expectations are that the remaining 294 firms will post total net income that is just 19.45% higher than a year ago. That is an acceleration from the year-over-year growth of the third quarter (13.49%). It now looks like the final year-over-year growth will be 25.8% — up from the implied level of 23.4% as of last week.
Given that positive earnings surprises almost always outnumber disappointments, that number implies that the remaining firms would have a median surprise of 0.00 and a surprise ratio of 1.00, which is highly unlikely. Thus growth will probably be well over to 25% again when all is said and done for the quarter. At the very start of earnings season, the expected growth was under 20%.
Revenue growth, though, is expected to slow down significantly, actually falling 1.37% — down from positive growth of 8.91% in the third quarter. On the other hand, revenue growth among those that have reported is very healthy at 7.88%.
The financials are a big part of the overall revenue growth slowdown, but not the entire story. Excluding them, revenue growth is expected to slow to 2.71% year over year from 8.57% in the third quarter. That is in marked contrast to those that have already reported, where revenue growth is up from 7.17% growth in the third quarter.
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 1.53%.
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 10.95%, or 9.46% if one excludes the Financials, up from 9.00% (8.83% excluding financials) a year ago, but down from 11.21% (9.59% excluding Financials) in the third quarter. The expected net margin for the remainder is 7.31% (6.77% excluding Financials) up from 6.03% (6.43% 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 8.67% in 2010 and continue climbing to 9.50% in 2011 and 10.13% 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 8.23% in 2010, 8.83% in 2011 and 9.39% in 2012.
Full Year Expectations
The expectations for the full year are very healthy, with total net income for 2010 expected to rise to $782.9 billion in 2010, up from $544.3 billion in 2009. In 2011, the total net income for the S&P 500 should be $898.1 billion, or increases of 43.3% and 14.7%, 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 $106.17. That is up from $57.68 for 2009, $82.62 for 2010 and $94.77 for 2011. In an environment where the 10-year T-note is yielding just 3.39%, a P/E of 15.7x based on 2010 and 13.7x based on 2011 earnings looks attractive.
With almost two 2011 estimates being raised for each one being cut (revisions ratio of 1.98), 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. 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. Just having a Democrat in the White House has historically meant good things for the stock market. In fact, in the 50 years since JFK “asked not what your country can do for you,” the S&P 500 has advanced by a total of 1220 points (from 59.96 to 1280.26 on 1/20/11). Of those, more than all of them (1455) have come with a Democrat in the Oval Office (22 years), while the market has lost a total of 234 points with a GOP President. (Of course, a point gained under Kennedy or Nixon was a bigger percentage move than a point gained or lost under G.W. Bush or Obama).
Political Gridlock an Obstacle
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 it is not raised, the U.S. Government could go into at least a technical default on its debt, and the Government would probably have to shut down (not immediately, as there are a few games that can be played, but if it were to last for more than a few weeks, shutdown and default is likely).
That is hardly something that will inspire confidence in the markets. While it is inconceivable that it 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 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 rising net margins, and resulting strong earnings growth.
Overall, Earnings a Major Positive
Still, companies are expected to continue growing their earnings nicely, and the 14.7% 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 14.7% is not exactly awful. Even on the revenue side the expected growth in 2011 of 4.77%, or 5.97% 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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