Earnings Trends: Strong 4Q, Despite Weak Financial Sector

With almost 90% of fourth quarter earnings in, it seems clear that it is a mixed bag at best.

On a median EPS growth rate basis, growth of 10.5% is in line with the double digit pace that we have come to expect. However, on a total net income basis this is the weakest season we have seen since the end of the last recession. In recent years, the normal ratio of positive surprises to disappointments has run about 3.0:1. This time around it is just 2.4:1. The median surprise tells a similar story, currently running at 2.8%, while over the last four years it ended up at 3.0% or better. Thus, on a median growth and surprise basis, this is a pretty "normal" quarter.

The bad news has been very concentrated in the Financial sector, and over 90% of the Financials have already reported. So far, the Financials have been responsible for almost half of all the earnings disappointments. It is the only sector with more disappointments than positive surprises.

The Consumer Discretionary sector has also been weak, showing median growth of just 4.8%, and a surprise ratio of 2:1 and a 2.5% median surprise. Add the disappointments in the Discretionary stocks to those in the financials and together the two sectors are responsible for over 60% of the disappointments. Put another way, excluding only the Financials, the surprise ratio is running at 3.6:1.

The clear winners in terms of median EPS growth have been Utilities and Energy, with respectable showings by the Health Care and Tech sectors. Both Tech and Industrials have been doing fantastically well on the surprise front, with surprise ratios of 6.1 and 7.8 respectively and median surprises of 7.7% and 3.1%, respectively. These two sectors are responsible for 34% of the total positive surprises and only 12% of all disappointments.

Looking at the expectations for those who are yet to report, there should not be major changes to the sector rankings. Utilities could drift down a little and Financials might dig themselves out of the hole a bit, but over all those that have been strong so far are expected to stay strong, and the weak to remain weak.

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Total Net Income Growth

The median year-over-year growth discussed above is the good news, things look far worse on a total net income basis. On a total net income basis, the fourth quarter can be summed up in a single word: UGLY. It is still, by far, the weakest quarter we have seen in a long, long time. Total net income reported is 18.1% below year-ago levels, although that is better than the 20.1% decline we were seeing last week, and the 29.0% decline two weeks ago.

On a median basis, the reporting firms are showing positive growth in earnings, just less positive than in previous quarters, on a total net income basis, earnings are plunging. Looking at all 437 firms that have reported, collectively they posted profits of $152.7 billion this quarter, down from the $186.7 billion they reported a year ago. However it very much looks like a tale of two markets, with Tech doing well and Financials doing awful.

Collectively, the 85 Financial firms that have reported so far are in the have lost $3.3 billion, whereas a year ago, those same firms earned $50.9 billion. Noteworthy firms in the red include Countrywide Financial (CFC), SLM Corp (SLM), Washington Mutual (WM), and perhaps most troubling of all Ambac (ABK) and MBIA (MBI). These numbers do not include non-recurring items, although parsing out when loan losses are non recurring in the Financials is problematic at times. Throw in the non-recurring items makes the total losses reported so far, much higher.

If we back out Financials, the rest of the S&P is reporting total net income growth of 14.9%, which is extremely healthy. Telecom is leading the pack but that is artificially boosted by the AT&T/Bell South (T) merger a year ago.

Tech so far is up 28.5%. It certainly appears that Tech will be one of the bright spots for the quarter. The Energy numbers include 27 stocks, and so far it looks pretty good with 21.9% growth. With the remaining firms expected to post growth of 54.2%, the sector should close with better than 20% growth. However that will not be enough to knock Tech out of the second spot. Health Care is also having a very good earnings season with 19.0% total net income growth.

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The Zacks Revisions Ratio

To help gauge the direction of the market, we take note of what analysts are thinking. By tallying their EPS changes, we can determine our revisions ratio. This ratio simply divides the total number of positive estimate revisions by the total number of estimate cuts. Thus, a high ratio is a bullish indicator and a low ratio is bearish. For the S&P 500 as a whole, a number below 0.80 or above 1.25 is generally significant. For individual sectors the distance from 1.0 should be greater for the numbers to be significant.

The revisions ratio is edging up, but is still deep in negative territory. Given the very strong surprise numbers (outside of Finance), one would normally expect strong revisions ratios. This, so far is looking like the story of the dog that didn’t bark. The normal reaction by analysts to a positive earnings surprise is to raise estimates for future periods. This does not seem to be happening this time. While there has been some upward drift to the revisions ratio, it is not very convincing as we approach the peak of total revisions for the quarter.

The revisions ratio for 2008 is 0.64, indicating about three estimate cuts for every two increases, this is up ever so slightly from 0.57 last week, and 0.51 two weeks ago. The total number of revisions is near its peak. Over the last four weeks there have been 3,088 changes in estimates: 1,202 up and 1,886 down, down 0.8% 26.1% from 3,113: 1135 up and 1,979 down last week. Either this week or next should mark the peak in terms of total revisions activity.

By far the sector that is faring the worst is the Financials where cuts outnumber increases by 5:1. Banks continue to get slammed, with double digit numbers of estimate cuts (and no increases) at firms like SunTrust (STI), Marshall & Iisley (MI), Fifth Third (FITB) and Wells Fargo (WFC).

Consumer Discretionary follows with a revisions ratio of 0.33, or three cuts per increase. While still very weak, it is an improvement over the more than four to one pace of two weeks ago.

Industrials have joined Health Care in positive territory, and Utilities are on the edge between positive and neutral territory. Overall the revisions picture, while not as dire as it was a month ago is still downbeat. The ratio of firms up to firms down was moderately weaker than the revisions ratio at 0.58.

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The 2009 revisions show that analysts are already revising their estimates downward on balance for the year. While stronger than 2008, the revisions ratio of 2009 is still very much in negative territory at 0.71.

As with 2008, the defensive Health Care sector is doing relatively well. This week they are joined in moderately positive territory by the Industrials and Utilities. The pictures for the Financials and Consumer Discretionary sectors continue to look bleak. In particular, the retailers are taking it on the chin. Firms with at least 10 cuts and no increases include Bed Bath and Beyond (BBBY), Family Dollar (FDO), Kohl’s (KSS) and Target (TGT).

The total number of revisions for the whole S&P 500 for 2009 is still relatively light, but are picking up, at 1,447: 600 up and 847 down. This is up 5.4% from 1,373 (555 up and 818 down) last week. Keep in mind that the numbers for some of the individual sectors are still very light. As with the FY1 numbers, the ratio of firms with rising mean estimates to falling mean estimates (0.69) confirms the revisions ratio.

Revisions FY2 (2009)

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Market Cap versus Total Earnings

When making investment decisions, growth should always be looked at in conjunction with how much you are paying for a stock. Thus, it makes sense to look at the total earnings expected for a sector, relative to that sector’s total market capitalization. This is basically a variation on looking at the P/E.

The chart below shows the share of total earnings for 2007, 2008 and 2009, as well as the share of total market capitalization for each sector (the final bar shown). Since the S&P 500 is a market cap weighted index, this is the same as its index weight. On the chart below, the difference between the sizes of the first three bars shows if a sector is gaining or losing "earnings share". The difference between the final bar and the first three bars shows if the sector is selling for an above or below market P/E. If the final bar is smaller than the other bars, the sector is selling for a below market P/E. However, as opposed to just showing the sector P/Es, it also shows the relative importance of the sectors to the overall index.

Despite their current problems, the Financials are still a very significant influence on the market, accounting for a much larger slice of the earnings in each year than any other sector. Even with all the disasters in the sector, for 2007, the Financials will account for 22.0% of the total net income for the S&P 500, and 22.1% in 2008. However, in recent years the sector has accounted for well over a quarter of all earnings. Thus even though the sector is the cheapest on a P/E basis, it just reclaimed it throne as the biggest total market cap sector (it is in a virtual tie with Tech).

The Financial sector makes up 17.2% of the total market capitalization of the index, followed by Tech at 15.8%. Given the ongoing massive cuts in estimates, please take the P/E on the Financials with a bag of rock salt. The true earnings are likely to be far lower than current estimates now suggest.

For many years Financials were clearly the dominate factor in the overall market. Based on 2008 earnings, the Financials have a P/E of only 10.7x and based on 2009, only 9.3x. However given the pace of estimate cuts in the sector, the true P/E is probably higher since the actual earnings will be significantly lower.

Energy is also very cheap based on 2008 and 2009 earnings expectations, trading at 11.0x and 10.3x, respectively. Unless the spreading of economic weakness to the rest of the world causes oil prices to plunge, you can have much more confidence in Energy earnings forecasts actually being achieved than is true with the Financials. While Energy accounts for only 12.7% of the total market cap of the S&P 500, it is responsible for 15.8% of 2007 earnings and is expected to be the source of 15.9% of 2008 earnings (falling to 15.0% in 2009).

This is almost a mirror image of Tech which has a 15.8% weight in the index but was responsible for only 11.7% of 2007 earnings. However, Tech’s earnings share is expected to rise to 12.5% in 2008 and 12.9% in 2009.

The S&P 500 as a whole is trading for 13.8x and 12.2x, respectively. Based on 2008 earnings, this translates to a 7.24% earnings yield, which looks extremely cheap relative to a 3.86% ten year T-note. Even against the A corporate bond yield of 5.85% it looks attractive. However, the current level of expectations for corporate earnings still imply that profits will stay well above their historical averages as a share of GDP. That would be an exceedingly rare occurrence during a recession.