Reasons to Be Bullish

The 4th quarter earnings season is almost three quarters done. We now have 372 or 74.4% 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 372 firms actually represent 84.2% 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, as those 372 firms also represented 84.8% of all the net income a year ago.

The reports are encouraging, with total net income for those firms rising 27.4% over a year ago. The median surprise of 3.83% is also fairly strong, although the ratio of positive to negative surprises is only somewhat above normal at just 3.44. The total net income growth of the reporting firms is a slight slowdown from the 28.7% growth those same firms posted in the third quarter.

Based on the expectations for the 128 yet to report, the final growth rate should be a bit higher than what we have seen so far, but there really are not enough of them (and the remaining firms are not big enough) to really move the needle. The expectations are that the remaining 128 firms will post total net income that is 34.1% more than a year ago. That is a big acceleration from the year-over-year growth of the third quarter of 9.45%.

Year-Over-Year Growth in Clearer Focus

It now looks like the final year-over-year growth will be 28.4%, down from the implied level of 28.7% 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 could be close to 30% 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 2.50%, down from positive growth of 8.43% those 128 firms reported in the third quarter. On the other hand, revenue growth among those that have reported is very healthy at 8.50%, actually higher than the 8.09% growth those 372 firms reported in the third quarter.

Looking ahead to the first quarter, though, those firms are expected to post year-over-year revenue growth of just 3.92%, while the yet-to-report firms are expected to see a revenue decline of 6.74% in the first quarter.

Excluding Financials

If the Financials are excluded, reported revenue growth is 8.81%, up from 8.09% in the third quarter, and slowing to 4.32% in the first 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 1.40%.

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 9.65%, or 8.54% if one excludes the financials, up from 8.22% (7.76% excluding financials) a year ago, but down from 9.93% (8.67% excluding financials) in the third quarter. The expected net margin for the remainder is 6.29% (6.02% excluding financials) up from 4.57% (5.86% ex-financials) last year.

Net Margin Expansion

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 8.68% in 2010 and continue climbing to 9.47% in 2011 and 10.07% 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 7.12% in 2009, but have started a robust recovery and are expected to be 8.21% in 2010, 8.75% in 2011 and 9.29% in 2012.

The expectations for the full year are very healthy, with total net income for 2010 expected to rise to $785.5 billion, up from $544.3 billion in 2009. In 2011, the total net income for the S&P 500 should be $902.7 billion, or increases of 43.8% and 14.9%, respectively.

The early expectation is for 2012 to have total net income passing the $1 Trillion mark to $1.012 Trillion. That will also put the “EPS” for the S&P 500 over the $100 “per share” level for the first time at $106.69. That is up from $57.62 for 2009, $82.82 for 2010, and $95.17 for 2011. In an environment where the 10-year T-note is yielding 3.63%, a P/E of 16.0x based on 2010 and 13.9x based on 2011 earnings looks attractive. The P/E based on 2012 earnings is 12.4x.

Reasons to be Bullish

With almost two 2011 estimates being raised for each one being cut (revisions ratio of 1.73), 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 almost the same rate, with a revisions ratio of 1.82.

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 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. Few, if any, binomial variables have as much statistical significance.

A Few Caveats

Overall, things are looking very good, but that does not mean that all is smooth sailing ahead. While the debt ceiling will eventually get raised — not doing so would be catastrophic — there will probably be some political theatre around it that could unnerve the markets. Internationally, things took a big turn for the better in Egypt this week, but the story there is far from over and could deteriorate still.

The economy does seem to have made a slow turn towards recovery. However, job creation remains very sluggish. That is particularly true if one goes by the establishment survey, which has shown only 157,000 jobs created over the last two months. The household survey has been much more upbeat, showing growth of 414,000 jobs over the same period, and the largest two month drop in the unemployment rate since 1958.

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 (higher profits), not labor (flat wages, slow hiring). That was seen again in the fourth quarter productivity report where productivity rose at 2.6% while unit labor costs dropped 0.6%. This is a major reason behind the rising net margins, and resulting strong earnings growth.

A New Record Expected by Mid-2012

Companies are expected to continue growing their earnings nicely, and the 14.9% 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. Solid growth of 12.1% is expected to continue into 2012.

With analysts, on balance, raising estimates for 2011 and 2012, increases the odds that that growth will be achieved. Growth of 14.9% is not exactly awful. Even on the revenue side, the expected growth in 2011 of 6.4% (or 10.0% if one excludes the Financial sector) is very solid. Clearly the analytical community is not expecting the economy to turn south again.

In the Quarter table below, reported refers to those firms that have already reported, while expected refers to those 128 firms that have yet to report. The annual numbers are for the whole S&P 500.

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