The third-quarter earnings results were better than expected. That doesn't mean, however, that they were good. Furthermore, guidance for the fourth quarter left a lot to be desired.
One Good Exclusion Deserves Another
According to FactSet, the third-quarter blended earnings growth rate was -3.1% on September 30. Today it is -0.9%.
That is the basis for saying the reporting period was better than expected. However, the 0.9% decline in earnings, along with the understanding that third-quarter revenue declined 1.2%, is the basis for saying the results in aggregate were not good.
Much of the blame for the earnings decline can be placed on the Energy sector, which experienced a 17.7% decline in third-quarter earnings. If it is excluded, FactSet notes the growth rate for the third quarter would improve to 2.3%.
Conversely, the Financials sector, which enjoyed 11.8% growth, is the main reason why the third-quarter blended growth rate wasn't worse. If the Financials sector is excluded, the growth rate for the third quarter would fall to -3.2%.
Exclusions notwithstanding, it all counts in the end.
An earnings and revenue growth summary for each sector is provided in the table below.
Q3 Earnings Growth
Q3 Revenue Growth
Lowering the Bar
In terms of negative surprises, they were concentrated on the top-line and in the earnings guidance for the fourth quarter.
Just 41% of S&P 500 companies reporting revenue exceeded expectations. According to FactSet, that is the lowest percentage of companies surpassing expectations since the first quarter of 2009.
The lackluster revenue growth is perhaps the most underappreciated aspect of the third-quarter reporting period. It shows that demand is weak and it indicates that earnings growth will be hard to come by if companies can't expand profit margins that are already near record high levels.
Plenty of companies sounded an earnings warning, too. Out of the 103 companies issuing fourth-quarter guidance, 73% issued negative EPS guidance. That is well above the long-term average of 61%.
The disproportionate number of warnings prompted analysts to lower their forward-looking estimates.
According to FactSet, fourth-quarter earnings growth is now projected to be 3.9% versus 9.3% at the end of September. The earnings growth estimate for the first quarter has been cut to 3.1% from 5.3%.
The downward revision to growth estimates is not a surprise to us. We said in our earnings preview October 8, that we expected growth estimates to come down given the weak macroeconomic conditions and the uncertainty regarding the presidential election and the fiscal cliff.
Q4 Earnings Growth
Q4 Revenue Growth
2013 Earnings Glass Still Half Full
The election uncertainty is over, but the fiscal cliff uncertainty is as high as ever. That uncertainty coupled with the stronger dollar, Europe's problems, and the slowdown in emerging markets were oft-cited explanations for disappointing guidance.
The earnings growth estimate for calendar year 2013, however, hasn't changed much. It stood at 11% at the end of September. Today it is 10%.
With projections for just 3% earnings growth in the first quarter, analysts are clearly expecting things to ramp up as 2013 unfolds.
Something else is also apparent in the table below. Considering earnings growth is expected to outpace revenue growth in every sector except the Utilities sector, analysts must be expecting strong profit margin expansion and/or strong share buyback activity in 2013.
CY13 Earnings Growth
CY13 Revenue Growth
At this point, we would argue that earnings growth estimates for CY13 are overly-optimistic given the ongoing struggles in Japan and the eurozone, and the drag that the fiscal cliff -- compromise or not -- will have on the U.S. economy.
Our economic outlook calls for muted growth in the first half of 2013 and a return toward a weak 2.0% growth rate in the back half of the year.
What It All Means
The third-quarter earnings reporting period came and went, largely overshadowed by the intrigue surrounding the presidential election and the fiscal cliff.
The earnings results themselves ended up being better than expected, yet that isn't saying much when better than expected equates to no growth.
Although estimates for the fourth quarter have been chopped down from silly heights, the double-digit growth estimate for calendar year 2013 is expecting too much. The eurozone and Japanese economies will be barely growing, if they are growing at all, and the U.S. economy will be fortunate to grow 2.5% even with a compromise on the fiscal cliff.
While there might be a relief rally on word of a fiscal cliff compromise, bear in mind that any compromise will be a drag on economic growth and that the revision risk for earnings growth will remain to the downside.
Those are risk factors that should not be forgotten by investors when headline hoopla prompts the market to take leave of its fundamental senses.
More directly, they are risk factors that support a defensive-minded approach to investing in the equity market.
Double-digit earnings growth expectations just don't mesh with the weak growth outlook for most of the world's largest economies.