The first quarter earnings season is off to a strong start. We now have 306 (61.2%) of the reports in. That actually understates things a bit, since the firms that have already reported are larger and more profitable than average and represent 69.5% of the total expected earnings for the quarter.
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 20.8%. While that is down from the extremely strong 28.1% those same 306 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.
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 22.8% so far, actually up from the 18.2% those firms reported in the fourth quarter. The remaining firms are not expected to do quite as well, and the hurdle is not particularly high.
The consensus is looking for a significant slowdown in growth for the remaining firms, with total net income rising just 7.3%, down from 36.7% in the fourth quarter. Excluding the Financials, growth of 12.9% is expected, down from 23.0% in the fourth quarter. 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 (almost a 10x increase).
The expected firms have not yet benefited from positive surprises the way the firms that already have reported have. In terms of surprises, this has been a very strong season so far, with a median surprise of 4.55% and a 4.02 surprise ratio.
Revenue Growth Also Up
Revenue growth so far is also strong at 8.77%, up from the 8.05% growth they posted in the fourth quarter. The firms yet to report are expected to post year-over-year revenue growth of 6.00%, down from 8.67% growth in the fourth quarter.
Financials are the key reason for the slowdown in revenue growth. If they are excluded, reported revenue growth is 12.12%, up from the 9.26% growth posted last quarter. The non-Financials yet to report are expected to see growth of 9.19%, a nice acceleration from the 6.91% growth in the fourth quarter.
Net Margin Growth Slowing
Net margin expansion has been a driver of earnings growth, but that expansion is slowing down, particularly if one excludes the Financials. Net margins for those yet to report are expected to come in at 7.60% in the first quarter, up from 7.44% a year ago, and from 7.23% in the fourth quarter. Excluding the Financials, net margins are expected to match the 7.17% of a year ago, but decline from 7.42% in the fourth quarter.
Among those that have already reported for the first quarter, overall net margins are 10.45%, up sharply from 9.41% a year ago and from 9.91% in the fourth quarter. Strip away the Financials that have already reported and the picture is somewhat different, rising to 9.71% from 8.87% a year ago and from the 9.57% reported in the fourth quarter.
Cyclicals Leading Growth
The more cyclical parts of the economy will be leading the growth charge this quarter. If we combine the reported results with the expected, the highest growth comes from the Materials sector, with growth of 47.05%, followed closely by Autos (43.31%), Industrials (41.75%) and Energy (38.67%).
At the other end of the spectrum are the “Steady Eddie” sectors. Growth will be a negative 4.61% for the Utilities. Anemic, but positive growth of 1.50% is seen for Staples and 4.26% for the Medical sector. Those figures assume no surprises among the remaining firms. For the S&P 500 as a whole, total growth should be 16.3% (18.2% ex-Financials) down from 30.7% in the fourth quarter (19.8% ex-Financials). Looking ahead to the second quarter, 11.4% total growth is now expected (13.1% ex-Financials).
On an annual basis, net margins continue to march northward. In 2008, overall net margins were just 5.88%, rising to 6.40% in 2009. They hit 8.61% in 2010 and are expected to continue climbing to 9.54% in 2011 and 10.24% 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 8.24% in 2010. They are expected to rise to 8.86% in 2011 and 9.35% in 2012.
Full Year Expectations
The expectations for the full year are very healthy, with total net income for 2010 rising to $794.0 billion in 2010, up from $544.7 billion in 2009. In 2011, the total net income for the S&P 500 should be $919.9 billion, or increases of 45.8% and 15.9%, respectively. The expectation is for 2012 to have total net income passing the $1 Trillion mark to $1.047 Trillion.
That would also put the “EPS” for the S&P 500 over the $100 “per share” level for the first time at $109.89. That is up from $57.19 for 2009, $83.36 for 2010, and $96.56 for 2011. In an environment where the 10-year T-note is yielding 3.40%, a P/E of 16.3x based on 2010 and 14.1x based on 2011 earnings looks attractive. The P/E based on 2012 earnings is 12.4x.
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 1.84 from 1.54. 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. The estimate increases are widespread, with the ratio of firms with rising mean estimates to firms with falling estimates standing at 1.65.
There is no “mechanical” reason for the estimates for 2012 to be rising. Those are even stronger than the ones for 2011. The 2012 revisions ratio is now at 2.06, meaning that upwards estimate revisions are out pacing cuts by more than 2:1 for next year. The ratio of rising to falling mean estimates stands at 1.81. Those are extremely bullish readings.
Potential Pitfalls
That does not mean 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 it will not happen, 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 from being a 0.34 point drag in the fourth quarter.
In other words, 0.75 of the total 130 basis 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 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.
Recently, the trend in Initial Claims for Unemployment has taken a nasty turn for the worse, with the four-week moving average going back above the 400,000 level for the first time since January. 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. We will know more about the job picture when the April employment report comes out on Friday.
International Questions
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. 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 with Portugal now also getting bailed out, even as the ECB makes life tougher on the PIIGS by raising rates.
Housing
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.
Weak Dollar Has Helped
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.
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 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.
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