The new year has arrived and soon so will another earnings reporting season. This time most companies will bring to light their results for the fourth quarter and the full year. They'll start doing so in earnest in mid-January, which means the next few weeks will be dotted with updated guidance from companies that now have a better sense of whether their results are going to measure up against consensus estimates.
We know already that the guidance coming out of the third quarter reporting period has been dominated by companies lowering expectations. To that end, FactSet informs us that 94 companies have issued negative EPS guidance for the fourth quarter versus just 13 companies that have issued positive guidance. In total, 88% of the companies guiding have guided lower versus a 5-year average of 64%.
The disparity is astounding and it helps explain why the fourth quarter EPS growth rate has been reduced from 9.6% on September 30 to 6.3% today. Ironically, the S&P 500 has increased 9.0% over the same period as the outlook for global economic activity has improved.
That suggests to us that there will be a high guidance bar for the first quarter since a lot of expected good news has been baked into stock prices already.
A Financial Fix
Looking at the fourth quarter, the financial sector will once again play a key role in driving the overall EPS growth rate. It is a bit of a special situation that boils down to an easy comparison for the insurers, which took a big hit to earnings last year due to the losses associated with Superstorm Sandy.
Bad weather again made its way to the Northeast in the fourth quarter, but thankfully it was the "normal" winter stuff that creates inconveniences rather than outright destruction. With that in mind, the financial sector is currently projected to deliver EPS growth of 24.1%.
That growth promises to make a big difference overall. If the financial sector is excluded, fourth quarter earnings growth for the S&P 500 would be just 2.9%.
Looking at the top line, S&P 500 revenue is expected to be up a mere 0.3%. Here the tables are turned as the financial sector is expected to see revenue decline 10.2%, which is the biggest decline for any sector.
It is a striking dichotomy to say the least: the strongest earnings growth and the weakest revenue growth. There is a special item in the mix, though, and it relates to a pension risk transfer transaction conducted by Prudential (NYSE:PRU) in the year-ago period that led to a huge jump in revenue that isn't going to be repeated this year. Accordingly, the financial sector's comparison for earnings is quite easy, but for revenues it is inordinately difficult.
If Prudential is excluded, the revenue growth rate for the sector improves to -0.3% and for the S&P 500 it improves to 1.6%. The table below shows the current revenue and EPS growth projections for all ten sectors in alphabetical order.
Q4 Revenue Growth
Q4 EPS Growth
First Things First
At this juncture, first quarter earnings are expected to be up 4.4%. We think that belies the high expectations embedded in stock prices, so while it may be easier to live up to analysts' expectations, companies may have a more challenging time moving the EPS outlook needle enough to satisfy the market's expectations.
A year ago the forward 12-month P/E ratio was 12.6. Today it sits at 15.4. Investors, therefore, are paying more for every dollar of earnings, which in turn means they will be demanding more for their money.
Companies that fail to deliver could be subject to material setbacks. There is nothing new with that assessment. It rings true every reporting season, but with the multiple expansions seen and the Fed now beginning to taper its asset purchases, guidance disappointments may not be dismissed so readily or recovered from so easily.
What It All Means
In 2013 the S&P 500 repeatedly leaped over lowered earnings growth expectations. It will likely do so again with the fourth quarter reports and it won't be any surprise if some financial engineering (i.e. share buyback activity) helps in the effort.
A lot of attention of course has been paid by us, and others, to profit margins being at record levels and the difficulty companies face sustaining those margins. Concerns about mean reversion with profit margins will be a recurring theme on the earnings front as 2014 unfolds.
In the next few weeks, corporate America will have the first pass at allaying those concerns or feeding them with their first quarter guidance.
Companies that feed them are at increased risk of a material setback in price because so many boats have risen with the broad market tide and have been priced on the expectation that good news is sure to follow.
Good news might follow, yet low-growth expectations aren't as low as they used to be, which means the bar for guidance has gone up with P/E multiples.