Earnings – 11 Straight Positive Quarters and still going Strong – But who’s Counting?
October 25th, 2011
Forget Europe – Forget China – Believe in the strength of the U.S. Market!
There has been too much focus, in the past, on Europe and its fiscal instability and other European-related headlines -- and lately questions relating to the growth pace in China and other major emerging markets -- which have constantly trumped positive domestic economic reports - -- this does not appear to be the recent case where company results are concerned – thank goodness!
The S&P 500 is up 15% from its October 4 lows. As of Friday, 136 of the S&P 500 have reported third-quarter earnings. Two-thirds (91) registered a positive earnings surprise. Analysts now project that third-quarter earnings will be 14.7% above last year’s third quarter, compared with analysts’ October 3 estimate of just 13.1%. Perhaps that explains the surprisingly strong October market rally.
This is the 11th straight quarter of positive earnings surprises — this is quite an achievement in itself – and now we are being introduced to more forward momentum – the complaints often heard, about the lack of growth on Wall Street, seem to be a myth!
Third quarter earnings results continue to fill the earnings calendar. The 136 companies that had reported as of Friday represented 25.2%, of the S&P 500 firms reporting earnings results. Those 25.2% of firms represent 39% of all expected earnings for the quarter (provided that the remaining 374 firms all report exactly in line with expectations).
The year-over-year growth rate for the S&P 500 is 12.13%. That is actually well above the 3.33% growth that those same 136 firms posted in the second quarter. However, the second quarter was distorted by some big hits to the financial sector, most notably Bank of America (BAC). This time it reported better-than-expected earnings and did not have the big “write off” it did in the second quarter. That resulted in a $12 billion swing in total net income between the second and third quarters.
If we exclude the financial sector, the year-over-year growth rate is just a bit higher at 13.51%, but it represents a far bigger slowdown from the second quarter, when growth was 22.71%. The remaining 364 stocks are expected to grow their profits 12.33% over last year, down from 22.71% growth in the second quarter. If we exclude the financials, the remaining growth in the third quarter is expected to slow to 11.99% year over year from 17.99%. Then again, at the beginning of earnings second quarter season, growth of 9.7% was expected; 12.2% ex-financials.
We will need another season where positive results surprises far outpace disappointments if we are going to match the second quarter growth rate. If we combine the already reported results with the expectations, it now looks like the final growth will come in at 12.25%.
While selected technology stocks are helping lead the overall stock market higher, financial stocks are still struggling. Despite the problems that financial stocks in Europe and the U.S. are having, the woes in the financial sector are causing a welcome exodus from value stocks (dominated by financials) to growth stocks. Many investors who went into cash during the European financial crisis are now tip-toeing back into stocks, especially now that the S&P 500 sports a higher dividend yield than 10-year Treasury bonds.
During the recent correction, the stock market experienced a “crisis of confidence” similar to the 1979 “malaise” when Jimmy Carter was President. However, the stock market tends to rally heading into a Presidential election year. In the interim, not only is the stock market basking in better-than-expected third-quarter earnings, but the seasonally strong time of year is fast approaching. Typically, the market soars from October to January in a strong year-end rally.
Bad news will always exist, but the difference this October is that the stock market continues to shrug off bad news while focusing on positive third-quarter earnings. These earnings reports calm our fears about a double-dip recession and provide some hard answers to the key questions motivating most investors: “Where’s the growth?” and “What direction now?” The financial markets are frankly tired of hearing the latest news from Europe regarding their sovereign debts, or the recapitalization of their banks, or the latest strike in Greece.
Forget Europe! The world keeps spinning and markets elsewhere are still growing!
Viewing the Future Expectations
Looking ahead, overall net margins are expected to be down only slightly from the second quarter at 7.97% versus 8.00% in the second quarter, but up from 7.61% a year ago. Excluding the financials, though, it looks like the expanding net margin party might be coming to an end, with only 7.17% expected, down from both the 7.94% level of the second quarter, and 7.59% a year ago.
On an annual basis, net margins continue to march northward. In 2008, overall net margins were just 5.88%, rising to 6.33% in 2009. They hit 8.57% in 2010 and are expected to continue climbing to 9.28% in 2011 and 9.84% 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 6.99% in 2009, but have started a robust recovery and rose to 8.18% in 2010. They are expected to rise to 8.82% in 2011 and 9.12% in 2012.
The expectations for the full year are very healthy, with total net income for 2010 rising to $793.6 billion in 2010, up from $543.4 billion in 2009. In 2011, the total net income for the S&P 500 should be $907.0 billion, or increases of 46.0% and 14.3%, respectively. The expectation is for 2012 to have total net income passing the $1 Trillion mark to $1.015 Trillion, for growth of 11.9%.
The S&P "EPS" – Surpassing $100
The Earnings per Share - “EPS”- for the S&P 500 will be over the $100 “per share” level for the first time at $106.43. That is up from $56.98 for 2009, $83.25 for 2010, and $95.10 for 2011. In an environment where the 10-year T-note is yielding 2.19%, a P/E of 14.6x based on 2010 and 12.8x based on 2011 earnings looks attractive. The P/E based on 2012 earnings is just 11.4x.
The Global Influence – or NOT!
Turning to the global economy, China’s growth rate seems to be more of an imposing problem than that of Europe, in real-terms to the impact on the U.S. Market. On Tuesday, China’s National Bureau of Statistics reported that GDP growth “slowed” to an annual pace of 9.1% last quarter, down from 9.5% in the second quarter and 9.7% in the third quarter of last year. This is like slowing down from rocket travel to jet travel! China’s industrial output surged 13.8% in September vs. a year ago. This is hardly indicative of an economic slowdown.
Some economists are concerned that China’s trade surplus is shrinking, but China’s soaring imports are caused by rising domestic demand, due to a rapidly-growing Chinese middle class. As a result, China’s economic growth is now more balanced than ever. In addition, a booming middle class is fueling strong economic growth in the rest of Asia, especially India and Latin America. As a result of this emerging demand, the International Monetary Fund (IMF) sees global GDP growth at 4% in both 2011 and 2012.
In Europe, of course, the economic outlook is murkier. Many European banks are in the midst of being recapitalized. On Tuesday, Moody’s downgraded Spain to A1 from Aa2 and said that “no credible resolution of the current sovereign debt crisis has emerged.” Moody’s also warned that France may lose its coveted AAA rating and issued a “negative” outlook, which often precedes credit downgrades.
American corporations continue to issue debt at extremely low interest rates, so that they can buy back their low-priced stock. For example, Coca-Cola recently issued 10-year bonds yielding 2.375% and short-term notes at only 0.05% above LIBOR. Since Coca-Cola’s return on equity (ROE) is 41.3%, and it can borrow at 2.375% or less, the company is aggressively buying back $2 billion of its stock, thereby boosting earnings per share!
This stock buyback frenzy will continue to lift profit in 2012. For the future the trend needs to be equalized between the high level of corporate earnings and the low valuations relative to them -- analysts need to increase their estimates for the firms to see this happen – the bulls would definitely be happier with this theme.
For your future investment outlook, companies with solid dividends, and for which the analysts are still raising their estimates for next year, may be beneficial to your portfolio.
Some of the names that meet those criteria are DuPont (DD), Eaton (ETN) and PPG Industries (PPG) and Phillip Morris (PM).