TBT ProShares UltraShort Lehman 20 plus Year Treasury

Third quarter earnings season was a good one, unfortunately we may not be able to say the same about the fourth quarter.  We got off to a very weak start, and while the last week was better, it just pushed the season from being very poor to mediocre at best.  

So far 290, or 56.0% of the firms have reported.  However, assuming that all the remaining firms report exactly in line with expectations, then 72.8% of all earnings are in.  Normally, when all is said and done, the median surprise runs about 3.00% and the ratio about 3.0.  So far, the median is at 1.92% and the ratio is 1.93.  Both up from last week, but still well below normal.  

While we don’t have the drama of multi-billion-dollar bank losses, this is the weakest start to an earnings season since the depths of the Great Recession.   In most recent quarters, we have started out of the gate much faster than that only to fade towards those levels. This time the reverse is try, but we are running out of real estate to catch up.  Total net income for the 290 that have reported is 5.59% above a year ago.  It is still less than a third the 18.25% growth rate that the same 290 firms reported in the third quarter.

The picture is just a little bit better if we take the Financials out of the picture.   Without them, the year-over-year rise in net income is 7.76%, down from 20.37% growth in the third quarter.  Sequentially, total net income so far is 7.01% below the third quarter, or 4.95% lower ex-Financials.  Last year the sequential growth was 4.14%, and 6.17% ex-Financials.  In other words, the pressure on the growth rate is coming from both the numerator and the denominator.

The bar is also set low for the remaining 210 firms, and significantly lower than the results we have seen so far.  They are expected to see year-over-year growth of just 1.74%.  If we exclude the Financial sector, earnings are expected to be 3.76% below last year’s.  That is far below the 5.90% total and 11.31% ex-Financial growth those 210 reported in the third quarter.  In other words, we have started out weak, and it is expected to get worse.

Revenue growth has held up better, with the 290 reporting 7.59% growth.  Most of the revenue weakness, though, has come from the Financials.  If we exclude the Financials that have reported, revenue is up 9.67% year over year.  The 210 are expected to see revenue growth to slow to negative 0.94% in total and positive 6.06% excluding the Financials.  In the third quarter, the 210 reported revenue growth of 9.24% in total and 10.23% excluding the Financials.  

Net Margin Expansion Ending

With revenue growth slowing, but holding up better than net income growth, it means that the net margin expansion game is coming to an end.  It has been a very big part of the spectacular earnings growth that we have seen coming out of the Great Recession.  

For the 290, net margins have come in at 9.84%, down from 10.03% a year ago, and down from 10.69% in the third quarter.  For the 210, margins are expected to be much lower, but they are lower-margin businesses to begin with.  They are, however, expected to rise to 7.21% from 7.02% last year, and up from the 6.82% in the third quarter. That is entirely due to the remaining Financials. Excluding Financials, net margins of just 6.52% expected, down from 7.18% a year ago and 7.13% in the third quarter.  

While in an absolute sense, those are still very healthy net margins -- much higher than the average of the last 50 years or so -- they are no longer expanding.  Then again, it was unrealistic to expect that they would always rise.  It does mean that earnings growth is going to be harder to come by going forward.

On an annual basis (all 500), net margins continue to march northward, but we are beginning to see cracks there as well.  In 2008, overall net margins were just 5.88%, rising to 6.27% in 2009.  They hit 8.51% in 2010 and are expected to continue climbing to 9.00% in 2011 and 9.24% in 2012.  The pattern is a bit different if the Financials are excluded, as margins fell from 7.78% in 2008 to 6.93% in 2009, but have started a robust recovery and rose to 8.12% in 2010.  They are expected to rise to 8.63% in 2011.  However, they are expected to drop to and 8.60% in 2012.

Net Income Still Looks Healthy

Total net income in 2010 rose to $788.8 billion in 2010, up from $538.6 billion in 2009.  The expectations for the full year are very healthy.  In 2011, the total net income for the S&P 500 should be $893.5 billion, or increases of 46.5% and 13.4%, respectively.  The expectation is for 2012 to have total net income come close to $1 trillion mark to $988.0 billion, for growth of 10.1%.  Consider those earnings relative to nominal GDP.  If we use the middle of the year GDP level, S&P 500 net income has climbed from 3.89% in 2009 to 5.45% in 2010, and assuming that the 2011 expectations are on target, 6.00% in 2011.  

Of course, the S&P 500 earns a lot of its income abroad (apx. 40%), and there are a lot more than 500 companies in the U.S., so to some extent that is an apples-to-oranges comparison.  It is somewhat ironic that the growth in earnings was robust when the economy was anemic, but now that the economy seems to be picking up, earnings growth is slowing down dramatically.  

Europe however is falling back into recession, and even if the Euro does not totally fall apart, it is likely to be a deep and nasty ditch.  The BRIC’s have also all shown signs of slower -- but still robust by developed country standards -- growth.  In their conference call commentary, many companies are blaming the slowdown in earnings growth on Europe, which represents about 15% of S&P 500 earnings.  

The “EPS” for the S&P 500 is expected to be over the $100 “per share” level for the first time at $104.05 in 2012.   That is up from $56.79 for 2009, $83.21 for 2010, and $94.21 for 2011.  In an environment where the 10-year T-note is yielding 1.83%, a P/E of 15.93x based on 2010 and 14.07x based on 2011 earnings looks attractive.  The P/E based on 2012 earnings is just 12.72x.  The P/E’s and T-note rates are as of Thursday (to keep it consistent with the earnings data) but on Friday the stock market was strong and the bond market was weak in response to the employment report.       

Estimate Revisions Activity Rising Fast

Estimate revisions activity is rising fast, and approaching a seasonal peak.   In previous earnings seasons we have generally seen a bounce in the revisions ratio, as the analysts have reacted to better-than-expected earnings and the outlooks on the conference calls.  So far there is no evidence of that happening.  

The revisions ratio for FY1, which is mostly 2011 earnings now stands at 0.57, or almost two cuts for every increase.  The cuts are very widespread, with only three sectors seeing more increases than cuts.  Eight of the sectors, including big ones like Energy, Health Care, Staples and Utilities are seeing more than twice as many cuts as increases.  The picture for FY2  is only slightly better, with a revisions ratio of just 0.64. Only three sectors are seeing more increases than cuts.  The widespread cuts are also confirmed by the ratio of firms with rising mean estimates to falling mean estimates, which now stand at 0.56 and 0.61, respectively.

As the earnings season has progressed, things have been getting a bit better, but only moved the season from being very poor to mediocre.   This is happening when the bar is set at its lowest point in a very long time.  For the remaining firms, that bar is set even lower.  

The market has been off to a very strong start of the year, despite the weak early results.  Valuations are still compelling, if somewhat less so than a few months ago.  However, if the results do not improve, it strikes me as likely that we will at least pause for a while.  The upcoming week will be a busy one, with 69 S&P 500 firms scheduled to report.

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