Despite worries about whether corporations would meet their Q1 2012 earnings expectations, on the whole, earnings season has been going quite well. Through May 3, with 423 of the S&P 500's companies having reported, the percentage that beat the consensus operating earnings estimate is hovering around 67% for the quarter, up from Q4 2011's 58.55%. So how long will the party last? Let's just say that roughly six to twelve months from now, CNBC will have to find even more creative ways to put a positive spin on anything and everything related to earnings season.
Over the past nine quarters, the trend has clearly been for slower year-over-year earnings growth. This is understandable considering the collapse in earnings that occurred during the worst part of the Great Recession. Below is a table showing the year-over-year operating earnings growth rate by quarter for the S&P 500 (SPY).
Yr. over Yr. EPS Growth
For Q2 2012, year-over-year earnings growth for the S&P 500 is expected to slow further to 4.14%. At the moment, Q3 is expected to come in at 6.33% year-over-year operating earnings growth. And then things change.
Beginning with Q4 2012, analysts are very, very bullish. For the S&P 500, earnings growth is expected to jump 19.68% year-over-year, pulling up 2012's yearly growth rate to 9.20%. Then, in 2013, earnings growth is expected to move back into double digits for the year, checking in at 13.42%. I can understand the argument that given last year's rough fourth quarter, comparisons to Q4 2011 will be easy enough to justify the Q4 2012 blowout estimates. However, even on a sequential basis, earnings are expected to grow at a rate quite different from recent history's Q4 experience. Even if we want to dismiss last year's negative 6.17% Q3 to Q4 earnings growth rate, it should be noted that in 2010, Q3 to Q4 only experienced 1.72% sequential growth. Currently, analysts are expecting a number of 5.62% in 2012.
In 2009, during the massive recovery in earnings off the lows, Q4 sequential growth came in at 8.75%. In 2008, Q4 S&P 500 earnings were negative, meaning a total collapse sequentially. I do recognize that it's unfair to compare Q4 2008 to anything, so we can throw that out and look at 2007 and 2006. Both of those years also had negative Q4 sequential earnings growth for the S&P 500. The last time sequential growth topped this year's Q4 expected growth rate (besides 2009's big bounce) was in 2005 when Q4 came in at 7.17%. However, during that year, earnings declined 3% sequentially from Q2 to Q3, helping to boost the Q4 number with an easier comparison. In 2012, analysts are expecting non-stop, strong sequential growth.
Furthermore, 2005 was a time when S&P 500 earnings were 27.63% lower than 2012 estimates and when one company alone didn't account for roughly one-third of profit growth, as Apple (AAPL) does today. Apple is so important to the stock market's earnings growth that it alone keeps technology earnings in the black. According to FactSet's John Butters, if you strip Apple out of Q1 2012 tech earnings, growth falls from 11% to a negative 2%. Whether you want to examine the year-over-year numbers or the sequential numbers, the bottom line is that analyst estimates are extremely optimistic beginning later this year.
Looking beyond Q4 2012 into 2013, investors should be asking themselves where the 422 basis points of extra earnings growth analysts are predicting for the S&P 500 (13.42% for 2013 versus 9.20% for 2012) will come from.
Given all the policy uncertainty surrounding tax hikes, the inevitable debt ceiling debate, and the outcome of the election, it's hard for me to imagine how analysts could, at this point, be predicting that 2013 will be the year the slowing earnings growth rate finally turns around with a vengeance.
Furthermore, let us not forget about the continued uncertainty in Europe about which I contend only positive outcomes are priced in. Moreover, during the past two months, economic report after economic report has been coming in weaker than expected (this week's strong jobless claims number notwithstanding).
Of course, we can also always worry about whether the Fed will give this easy-money-addicted market another jolt in the form of QE. From what I can tell, the financial markets have come to expect a new round of QE every six to eighteen months and have likely reached the point where unless QE comes in at ever larger numbers, it will begin to have diminishing returns over time (similar to Japan's ongoing QE experience). If we don't get the next round of QE by early 2013, it's hard for me to imagine the market not selling off from here. And, until I can see the economy stand on its own two feet without QE propping up stocks and instilling confidence (perhaps a false sense of confidence) among corporations and consumers, I'll err on the side of lower stocks eventually leading to lower earnings, not the other way around.
With all that said, let's take a look at the quarter-by-quarter earnings growth expectations for the S&P 500 as well as each of its ten sectors:
Year-over-Year EPS Growth
If you look at this table and think to yourself, "These analysts are nuts," then the question should be where to focus your efforts in terms of getting short or readjusting your long portfolio. When scanning this table, Consumer Discretionary (XLY), Information Technology (QQQ), and Materials (IYM) stand out as sectors expected to have quite aggressive growth from Q4 2012 through Q3 2013. Keep in mind that even if these sectors or particular stocks within these sectors grow but simply grow not as fast as expected, it should not be surprising if those stocks decline as they experience multiple contraction and/or new lower estimates. If the market is forward looking, and it is staring at very high growth expectations beginning in the fourth quarter of 2012, investors should prepare themselves for the very real possibility that the string of several years of positive earnings surprises may come to an end this fall or in Q1 2013.
In closing, it should be noted that even if earnings growth misses expectations over the coming twelve months, you will likely hear many financial pundits claim that the major indices will continue to go much higher and meet their price targets as a result of multiple expansion. I've heard all the arguments that the market is cheap based on its multiple before. And that may be. But keep in mind that the market-wide multiple has been on a downward trend for many years now and until proven otherwise, the trend is your friend. If numerous quarters of solid earnings beats haven't been enough to change the direction of the market's multiple, it's hard to believe that earnings misses late this year or early next year will do the trick. Although, I suppose the S&P 500 could break to new all-time highs if the Fed is willing to give in to the screams for more and ever larger QE that will inevitably accompany any decent size pullback in stocks or market-wide miss in earnings.