By Dirk van Dijk
While the first quarter earnings season "officially" kicked off last week when Alcoa (NYSE:AA) reported, it was a slow start. We have just 32 (6.4%) first quarter reports in. It will pick up steam this week, when 111 members of the S&P 500 are due to report.
This week’s reporters are a virtual who’s who of American business, from Apple (NASDAQ:AAPL) to Verizon (NYSE:VZ) and from Ford (NYSE:F) to McDonald’s (NYSE:MCD). While far too early to draw any conclusions, it looks like we are off to a good start in the first quarter, with reported net income growth of 33.4%, actually up slightly from the 32.4% growth those same 32 firms reported in the fourth quarter.
This Week Will Tell A Lot
By next week we should have a good idea of how the season as a whole will go. The expectations for the remaining firms have been rising, but the hurdle is not particularly high. The consensus is looking for a significant slowdown in growth for the remaining firms, with total net income rising just 16.8%.
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 the story so far in the first quarter. Excluding the Financials, total net income is up 16.5%, down from growth of 24.2$ in the fourth quarter.
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, the expected net income growth for the remaining firms is solid at 20.9%, actually up from the 19.5% growth those same firms posted in the fourth quarter.
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 3.66%, down from 8.19% growth in the fourth quarter. Financials are the key reason for the slowdown in revenue growth, if they are excluded, reported revenue growth is expected to be 7.46%, while that is down from the 8.22% growth posted last quarter, it is not nearly as dramatic. Tougher year-over-year comparisons are a big part of the story.
Net Margin Expansion Slowing
Net margin expansion has been a driver of earnings growth, but that expansion is slowing down, particularly if one excludes the Financials. Net margins for those yet to report are expected to come in at 9.77% in the first quarter, up from 8.67% a year ago, and from 8.80% in the fourth quarter. However, excluding the Financials, net margins are expected to rise to 9.25% from 8.22% a year ago, and up from 8.78% in the fourth quarter.
Among the handful that have already reported for the first quarter, overall net margins are 10.54%, up sharply from 8.40% a year ago and from 9.73% in the fourth quarter. Strip away the Financials that have already reported and the picture is different, rising to 8.30% from 7.82% a year ago and from the 7.88% reported in the fourth quarter.
Look to Cyclicals
It looks like the more cyclical parts of the economy will be leading the growth charge this quarter. The highest expected growth (among those yet to report) comes from the Construction sector, where earnings are expected to be more than double what they were last year, but in that case, so what, two times nothing is still nothing. The Industrials, on the other hand, had decent earnings a year ago, but are expected to report total net income that is 77.2% higher than in the first quarter of 2010.
Unlike the construction firms, analysts have been raising the expectations for the Industrials, for both 2011 and 2012, while they continue to slash the estimates for the construction firms. The Transports are also expected to see robust growth of 62.9% over last year. They are an interesting case in terms of estimate revisions, with cuts for this year, but lots of increases for next year. I suspect that what analysts are saying is that the underlying business is very strong, but that they face a stiff headwind in the near term from higher energy costs.
The Energy sector is also expected to have very strong growth, which is not a shocker if you have filled up your tank lately. Total net income for the quarter is expected to rise 45.2%, and the revisions are strong for both years.
The weakest sector by far is expected to be the Conglomerates, with earnings falling 45.5%. Utilities are also expected to have a weak performance, with total income down 9.0% from last year.
The Financials are expected to post positive growth, but only of 0.6%. They are a bit of a wild card, in that how good a quarter they have will largely depend on how much the banks can release reserves. Some will have major releases, and others very little at all. The level of releases can be very hard to forecast at any given bank. The quality of earnings growth coming from reserve releases is very low.
On an annual basis, net margins continue to march northward. In 2008, overall net margins were just 5.88%, rising to 6.40% in 2009. They hit 8.59% in 2010 and are expected to continue climbing to 9.50% in 2011 and 10.18% 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 7.08% in 2009, but have started a robust recovery and rose to 8.22% in 2010. They are expected to rise to 8.82% in 2011 and 9.29% in 2012.
Expectations for 2011
The expectations for the full year are very healthy, with total net income for 2010 rising to $792.1 billion in 2010, up from $545.1 billion in 2009. In 2011, the total net income for the S&P 500 should be $913.5 billion, or increases of 45.4% and 15.3%, respectively. The expectation is for 2012 to have total net income passing the $1 Trillion mark to $1.037 Trillion.
That will also put the "EPS" for the S&P 500 over the $100 "per share" level for the first time at $108.72. That is up from $57.13 for 2009, $83.09 for 2010, and $95.81 for 2011. In an environment where the 10 year T-note is yielding 3.50%, a P/E of 15.8x based on 2010 and 13.7x based on 2011 earnings looks attractive. The P/E based on 2012 earnings is 12.1x.
With far more estimates being raised than being cut (revisions ratio of 1.40), 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 1.86, or almost two increases for every cut. 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.
The Economy & Politics
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 than when the GOP holds the Oval Office.
While counting points on the S&P 500 is suspect over long periods of time, the fact remains that on balance, every single point of increase in the S&P 500 over the last 50 years has come with a Democrat in the White House. Those factors should combine to make this a good year for the market.
Not All Smooth Sailing
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 fewer jobs being created. Fortunately, the economy has some upward momentum, so the cuts will simply slow the economy down, not throw it into reverse.
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.
The idea that one can reduce unemployment by cutting jobs is positively Orwellian, and it is hard to believe the advocates of doing so are taken 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.
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 under way. Many U.S. made products have parts which are made in Japan and that is likely to disrupt production here. Still, there appeared to be no impact on Industrial Production in March as manufacturing output climbed 0.7%.
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. 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, and that will be a significant positive for the economy. 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, up only 0.1% in March and 1.2% year over year. That should let the Fed stay on Easy Street as far as monetary policy is concerned.