If a picture is worth a thousand words, then look at the graph below of the S&P 500. Unlike the last few earnings seasons, there are high expectations for Q1 2013. A similar pattern occurred last year and the S&P 500 peaked right before the start of the Q1 2012 earnings season. Before the European crisis of last summer, the S&P 500's ascent was halted by Q1 earnings. Therefore, I am watching Q1 2013 earnings closely to see if there is more fuel for the current rally or not. The work for Q1 earnings season begins now by looking at the pre-earnings changes to analyst estimates, which are discussed below. Although there are parallels to 2012, there are also some key differences that are also discussed below. Get ready to open all those Excel models, earnings are coming!
In the current environment of Federal Reserve life support (QE Infinity and low interest rates), political dysfunction in Washington and an ongoing crisis in Europe, I do not expect the S&P 500 to experience much multiple expansion. Multiple expansion occurred off the extreme lows when investors realized the world was not going to end and it will occur again when animal spirits come back to the market. For now, the market is in an in-between phase when multiple expansion will be muted and earnings growth (or lack thereof) will be a key driver for stock prices. Therefore, the S&P 500 needs confirmation, in the form of a good earnings season, to give it fuel for more gains. Furthermore, earnings of technology and cyclical companies will be especially important, since those sectors lagged recently and they are good indicators of risk appetite.
I am breaking down the analysis of Q1 earnings season into 4 parts. (1) Analysis of analyst changes pre-earnings: are analysts lowering/raising their expectations and what does this mean for the quality of the actual results. (2) Analysis of the actual results and updated forward guidance. (3) Focus on the earnings of the technology and cyclical sectors. (4) Market reaction to earnings. This article deals with the first part.
S&P 500: Q1 2013 and Q1 2012
The following chart illustrates the growing expectations for Q1 earnings as measured by the S&P 500's price action and the parallels to last year. Alcoa's (AA) earnings dates are used to represent the beginning of each quarter's earnings season. The boxes represent the periods between the Q4 and Q1 earnings.
Analysis of Q1 2013 Pre-Earnings
The tables and charts in this section look at the top 100 companies in the S&P 500, which have a combined weighting of 64.3% of the index. Because the index in capitalization weighted the largest companies matter the most. The company with the smallest weighting in this group is BlackRock (BLK), which represents 0.23% of the index, so the other 400 companies have a very small impact each. Please note that the weightings change daily.
The fist table looks at the number of positive and negative revisions to EPS estimates over the last 30 days for the top 100 companies in the S&P 500. FQ1 and FQ2 represent the current and next fiscal quarters and FY1 and FY2 represent the current and next fiscal years (please note companies are on various fiscal cycles).
Clearly, there have been a lot more instances of analysts upgrading EPS estimates. This seems to confirm the thesis that expectations are rising for Q1 earnings.
(Source: Yahoo Finance)
The previous table looks at the EPS revisions in aggregate, so it is helpful to also look at the EPS estimates from other angles.
The next chart goes into more detail about each of the top 100 companies in the S&P 500 (listed by rank from the top down). This chart displays the % (decrease)/increase in EPS estimates for FQ1, the current fiscal quarter. The black bars show the change over the last 30 days and the orange bars show the change over the last 7 days.
There is a lot of information in this chart and it is best to start with a high level observation: the changes in EPS estimates are roughly evenly split between the positive (right) side and the negative (left) side. From this perspective, the sentiment in the analyst community is not as positive as implied by the previous table.
This can be explained as follows. There has been a roughly even split between positive and negative revisions to EPS estimates, but more analysts are backing up the positive revisions.
(Source: Yahoo Finance)
The next two tables display the sales and EPS growth rates that are implied by the current analyst estimates. Although the S&P 500 is capitalization weighted, these tables take the mean and median on an unweighted basis.
In general, the sales and EPS growth rates seem reasonable. The current fiscal quarter has the most modest growth rate and there is an acceleration over time.
For FQ1, the mean and median sales growth rates are 4% and 3%, respectively, and the mean and median EPS growth rates are 3% and 5%, respectively. This does not seem like a high hurdle.
Sales growth and EPS growth are expected to accelerate over the course of the fiscal year. The FQ2 revenue and EPS growth rates are higher than in FQ1. Similarly, the FY1 revenue and EPS growth rates are higher than in FQ1.
The overall sales and EPS growth rates for this fiscal year, FY1, also seem reasonable with mean and median sales growth of 5% and 4%, respectively, and mean and median EPS growth of 8% and 9%, respectively.
(Source: Yahoo Finance)
Key Differences Between Q1 2013 and Q1 2012
Although I mentioned above that there seem to be parallels between the S&P 500's price action in Q1 2013 and Q1 2012, there are a few key differences worth mentioning.
The Federal Reserve is now much more supportive of the market. At this time last year, the Fed was engaged in Operation Twist, which was supposed to expire at the end of June. Continued Fed support for the market was unclear at that time. We now have QE-infinity, which seems closer to the beginning than the end. Currently, I think that QE-infinity will continue until the end of Ben Bernanke's term as chairman of the Fed. Furthermore, the ECB and the Bank of Japan have a "whatever it takes" approach to monetary policy.
There also was a lot more fiscal uncertainty last year. The US election season was underway and the market was sandwiched between the US debt downgrade and the Fiscal Cliff. Although there are issues in Europe now, Europe was in crisis then too. My theory about these manufactured crises in the US and Europe is that each time they come back there will be less and less of an impact on the market. Eventually when the market is very complacent about the fiscal issues there will be a big sell-off.
Finally, in addition to watching earnings closely, I am also interested in following the employment situation. Around this time last year, there was a steep drop in the jobs numbers. We'll see if the recent strength in employment is sustainable. The following chart shows the jobs numbers over the last two years.
(Source: Bureau of Labor Statistics, U.S. Department of Labor)
As I finish this article, late Sunday night, the lead article on Bloomberg.com is "Euro, U.S. Stock Futures Decline on Cyprus; Gold Gains." Maybe, the annual spring European crisis is here. However, I am reserving judgment about the European situation. After an impressive rally in the S&P 500 up to the previous highs, it seemed like the market needed a break anyway.
By contrast, Q1 earnings are very important for the market. The recent rally has priced in high expectations for earnings and the market will need confirmation in the form of good earnings to continue upward. Last year, Q1 earnings were the initial catalyst for the pullback, not the European crisis.
In the three weeks until Alcoa releases its earnings it is important to see if analysts revise their estimates up or down. If we see a lot of negative revisions, then results that meet or beat expectations might not be enough to fuel a further rally in the S&P 500.
So far, the indicators seem encouraging. The top 100 companies in the S&P 500 seem to have experienced an roughly even split of positive and negative earnings revisions and the positive revisions have been backed by more analyst actions. More importantly, the sales and growth expectations seem modest, so companies may be positioned to surprise on the upside. Let's continue to follow the developments as the quarter ends and reporting season begins.
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