By Dirk van Dijk
The fourth quarter earnings season is over, and now the focus turns to the first quarter. While it “officially” kicks off after the bell today when Alcoa (NYSE:AA) reports, we already have 26 (5.2%) first quarter reports in from the S&P 500.
Alcoa, though, like the Master’s -- is but the first of the majors. It will not be the only one in the early going. We will also hear from Google (NASDAQ:GOOG), J.P. Morgan (NYSE:JPM) and Bank of America (NYSE:BAC) this week. Together, they should provide some good clues to the overall direction of earnings season.
One firm which is not a household name but we be good to keep an eye on is Fastenal (NASDAQ:FAST). It is the number one maker of fasteners -- things like screws and bolts -- which go into all sorts of other things. If it reports strong results, it is a good bet that the rest of the market will, as well.
Good Start, but Earnings Growth to Slow
While far too early to draw any conclusions, it looks like we are off to a good start on the first quarter, with reported net income growth of 22.7%, down just slightly from the 25.7% growth those same 26 firms reported in the fourth quarter. That, however, is not expected to last. The consensus is looking for a dramatic slowdown in growth for the remaining firms, with total net income rising just 7.71%.
Financial firms setting aside much less than a year ago for bad debts were a big part of the earnings story for the fourth quarter, and a big part of the deceleration in year-over-year growth has to do with a much higher base, particularly in the Financials in the first quarter of 2010 than in the fourth quarter of 2009. If the Financial sector is excluded, total net income rose 19.8% from a year ago, in the fourth quarter, and in the first quarter it is expected to slow to 9.3%.
Positive Surprises Expected?
Given the trend of positive earnings surprises, I would be shocked if the actual growth rate is that low. It is almost certain to be in the double digits again. Revenue growth in the fourth quarter was healthy at 8.28%. Looking ahead to the first quarter, though, those firms yet to report are expected to post year-over-year revenue growth of just 4.14%.
Financials are the key reason for the slowdown in revenue growth; if they are excluded, reported revenue growth is expected to be 9.08%. Tougher year-over-year comparisons are a big part of the story.
Net Margins to Expand Slightly
Net margin expansion has been a driver of earnings growth, but that expansion is slowing down, particularly if one excludes the Financials. Overall, net margins are expected to come in at 9.03% in the first quarter, up from 8.73% a year ago, and from 8.92% in the fourth quarter. However, excluding the Financials, net margins are expected to only creep up to 8.29% from 8.27% a year ago, and down from 8.81% in the fourth quarter.
Among the handful of S&P 500 companies that have already reported for the first quarter, overall net margins are 7.92%, up sharply from 7.06% a year ago and from 7.06% in the fourth quarter. Strip away the Financials that have already reported and the picture is different, rising to 7.62% from 7.86% a year ago and from the 7.30% reported in the fourth quarter.
Do not make too much of the level of reported net margins being significantly lower than the expected net margins. That is due to the reporting firms being very overweighted towards retailers (many have February fiscal period ends), which tend to be lower-margin businesses.
On an annual basis, net margins continue to march northward. In 2008, overall net margins were just 5.88%, rising to 6.39% in 2009. They hit 8.59% in 2010 and are expected to continue climbing to 9.59% in 2011 and 10.31% 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 7.09% in 2009, but have started a robust recovery and rose to 8.24% in 2010. They are expected to rise to 8.84% in 2011 and 9.37% in 2012.
Another Good Year Overall?
The expectations for the full year are very healthy, with total net income for 2010 rising to $790.5 billion in 2010, up from $545.1 billion in 2009. In 2011, the total net income for the S&P 500 should be $909.5 billion, or increases of 45.3% and 15.1%, respectively. The expectation is for 2012 to have total net income passing the $1 Trillion mark to 1.036 Trillion.
That will also put the “EPS” for the S&P 500 over the $100 “per share” level for the first time at $108.50. That is up from $57.13 for 2009, $83.16 for 2010, and $95.67 for 2011. In an environment where the 10-year T-note is yielding 3.54%, a P/E of 16.1 based on 2010 and 14.0x based on 2011 earnings looks attractive. The P/E based on 2012 earnings is 12.3x.
With far more estimates being raised than being cut (revisions ratio of 1.32), one has to feel confident that the current expectations for 2011 will be hit, and more likely exceeded. Analysts are raising their 2012 projections at an even higher rate, with a revisions ratio of 1.74. While a lot can happen between now and the time the 2012 earnings are all in, upward estimate momentum means that the current 2012 earnings are more likely to be exceeded than for them to fall short.
This provides a strong fundamental backing for the market to continue to move higher. The fact we are in the third year of the presidential cycle (almost always the best of the four, and by a big margin). We have a Democrat in the White House, which has historically meant good things for the stock market, with an average annualized return over the last 50 years more than triple that when the GOP holds the Oval Office. Few, if any, binomial variables have as much statistical significance. Those factors should combine to make this a good year for the market.
Government Not Shutdown - But At What Cost?
That does not mean that all is smooth sailing ahead. We managed to avoid a government shutdown, but only at the cost of large spending cuts that will slow the economy. Those should probably shave at least a half point off of the growth we would have had in 2011, and probably result in hundreds of thousands of fewer jobs being created.
The lower growth will result in lower tax collections, so the impact on the budget deficit will be much less than the amount advertised. Job creation remains sluggish, but is starting to show signs of picking up. We created 230,000 jobs in the private sector in March, down from 240,000 in February, but that is after a big upward revision to the February numbers.
However, State and Local governments laid off a total of 15,000 people for the month, on top of 46,000 pink slips the month before. Those jobs count just like private sector jobs, and are a major headwind to bringing down the total number of unemployed. The idea that one can reduce unemployment by cutting jobs is positively Orwellian, and it is hard to believe the advocates of this message are taken so seriously.
The household survey has been much more upbeat, showing growth of 291,000 jobs in March, on top of 250,000 gained the month before. The unemployment rate fell to 8.8%, and it was as high as 9.8% as recently as November.
International Headwinds Remain
The international situation clearly has the potential to abort the recovery as well. The disaster in Japan will clearly slow its economy dramatically in the first quarter, although much of that growth will be made up later in the year as the reconstruction process gets underway. Many U.S. products have parts that are made in Japan, and that is likely to disrupt production here.
The turmoil in the Middle East is not going away, and that is likely to keep oil prices both high and volatile. High oil prices will also act as a depressing force on the economy. It is worth noting that many of the S&P 500 firms seeing the largest increases for this year’s earnings are oil companies. Owning some oil company shares can be a great hedge for rising prices at the pump.
The debt crisis in Europe is not going away with Portugal now also getting bailed out, even as the ECB makes life tougher on the PIIGS by raising rates. On the plus side, the dollar has been weak, and that should improve the trade deficit, particularly the non-oil side, and that will be a significant positive for the economy.
It also means that the foreign operations of U.S. companies will be much more profitable when the results are measured in dollars. Inflation, other than in food and energy, is well contained, and that should let the Fed stay on Easy Street as far as monetary policy is concerned.