Remaining Bullish Overhead

The first quarter earnings season is almost done. We now have 458 (91.6%) 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 17.9%. While that is down from the extremely strong 32.4% those same 458 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 Financials

It’s not that the Financials are having a bad quarter, but they do face much tougher comps this time around. It is not like the 8.7% year-over-year growth they are reporting is awful (although it is below the rest of the S&P 500), it is that it pales in comparison to the 161.8% growth posted in the fourth quarter. That is despite a very strong sequential growth of 22.0%.

If we back out the Financials, total net income is up 19.9% so far, down just slightly from the 20.4% 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 10.7%. Back out the Financials and growth is expected to be 13.1%.

Revenue growth is also very strong at 9.38%, up from the 9.03% 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 second quarter, falling to 4.62% year over year for the S&P 500 as a whole. That is mostly a Financial story. Revenue growth is only expected to slip to 9.33% if the Financials are excluded.

Net Margin Expansion

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 9.86%, up sharply from 9.18% a year ago and from 9.31% in the fourth quarter. Strip away the Financials and the picture is somewhat different, rising to 8.57% from 7.88% a year ago and from the 8.32% reported in the fourth quarter.

The more cyclical parts of the economy are leading the growth charge this quarter. The highest growth comes from the Industrials sector, with growth of 76.1%. Three other sectors are posting growth over 40%: Materials (48.3%), Autos (46.9%) 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 1.2% from a year ago. Anemic — but positive — growth of 3.5% has been posted for Staples.

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 8.60% in 2010 and are expected to continue climbing to 9.48% in 2011 and 10.17% 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 8.82% in 2011 and 9.31% in 2012.

Full-Year Expectations

The expectations for the full year are very healthy, with total net income for 2010 rising to $792.4 billion in 2010, up from $544.7 billion in 2009. In 2011, the total net income for the S&P 500 should be $922.7 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 $1.046 Trillion.

That will also put the “EPS” for the S&P 500 over the $100 “per share” level for the first time at $109.74. That is up from $57.12 for 2009, $83.10 for 2010, and $96.82 for 2011. In an environment where the 10-year T-note is yielding 3.22%, a P/E of 16.2x based on 2010 and 13.9x based on 2011 earnings looks attractive. The P/E based on 2012 earnings is 12.3x.

Analysts Upping Estimates

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 sitting at 1.92. 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. A few weeks from now, that will not be the case as revision activity will plunge.

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 1.98. There is no “mechanical” reason for the estimates for 2012 to be rising.

The 2012 revisions ratio is now at 2.06, 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 1.93. Those are extremely bullish readings.

Fundamentally Good News, but Not All Smooth Sailing

This provides a strong fundamental backing for the market to continue to move higher. It is important to keep your eyes on the prize. There is lots of news out there, and much of it is more dramatic than earnings results, but rarely does it have more significance for your portfolio.

Earnings are, and are going to remain, the single most important thing for the stock market. Interest rates are an important — but distant — second.

That does not mean that all is smooth sailing ahead. We are now at the softest part of the year (historically). There is a fair amount of truth to the old adage “Sell in May, but remember to return by November.”

The fight over raising the debt ceiling is now underway. 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 Congress would let that happen. While not the most likely case, the chance of no increase by the time the ceiling is hit is a very real possibility. Given the disastrous potential consequences, taking out some insurance in the form of deep out-of-the-money puts would make a lot of sense at this point.

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, up from being a 0.34 point drag in the fourth quarter. In other words, 75 of the total 130 basis point growth slowdown (57.8%) was due to increased austerity in Government spending.

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.

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. While we got some relief this week, with a drop of 43,000 new claims, we need to see that number continue to decline. Those numbers were not reflected in the April jobs report, but they are not a good omen for the May report.

Unemployment Rate

The unemployment rate bounced back up to 9.0%. This was not due to, as many assume, people coming back into the labor force. It was due to the fact that the unemployment rate is derived from a separate survey from the one that measures the number of jobs gained or lost. The civilian participation rate has been stuck at the same low 64.2% level since January.

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. The rate of headline inflation has been moving higher, but it is only up 3.2% over the last year. That is lower than what we have experienced for most of the last 40 years.

Furthermore, commodity prices have just fallen sharply, so we might start to see some relief very soon. Core inflation remains very low, up just 1.3% over the last year. 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 with Portugal now also getting bailed out, even as the ECB makes life tougher on the PIIGS by raising rates. Rates for the Greek, Irish and Portuguese debt are substantially higher than when the crisis first started. The austerity campaigns have weakened those economies and undermined tax revenues, and so the bailouts have not made the situation much better.

Here at home, the housing situation has not been showing many signs of improvement, and I doubt we will see much in the housing-related numbers due out this week. Note that the Construction sector is the weakest in terms of both surprises and estimate revisions.

Remaining Bullish Overhead

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 have some put protection in place) if it looks like the debt ceiling will not be raised.

As far as individual stock picks are concerned, look for the combination of a Zacks #1 Rank, with moderate P/Es and a reasonable dividend yield. The current issue of Earnings Trends has a list of the firms with the largest positive revisions for this year.

The best hunting ground for such firms seems to be in the Industrial, Materials and Energy sectors, but things are not limited to them. Some of the names to consider among the S&P 500 include AK Steel (AKS), Caterpillar (CAT), Cummins (CMI), Dow Chemical (DOW), United Health (UNH) and Valero (VLO).

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