Drowned out in all the drama unfolding in Europe is the fact that S&P 500 companies just posted their worst pre-announcement period since the third quarter of 2001 -- right after the 9/11 terrorist attack.
The slew of negative pre-announcements have spanned the entire gamut of S&P sectors including consumer staples companies such as Procter and Gamble (PG), technology companies such as Texas Instruments (TXN) and transportation companies such as FedEx (FDX).
I believe that 2Q 2012 will in hindsight be seen as a key turning point in the bear market cycle that I am predicting. I project expectations for 12-month forward earnings growth to go from highly positive to strongly negative between now and the end of 2012. The disappointment and shock that derived from downwards adjustments of earnings expectations will become a key driver of a bear market that has only just begun.
Negative Earnings Trends
To get a flavor for where the trend in S&P 500 earnings is going, consider the following:
- Pre-announcements. Going into 2Q 2012, the negative pre-announcement ratio is the worst since the third quarter of 2001 -- when the 9/11 terrorist attack spooked many companies into lowering earnings guidance.
- EPS estimate contraction. Bottom-up YoY earnings growth expectations for 2Q 2012 have contracted from 6.4% on March 31, 2012 to 3.0% currently.
- Sales estimate contraction. Bottom-up YoY revenue growth expectations for 2Q 2012 have contracted from 3.4% on March 31, 2012 to 1.5% currently.
- Negative earnings momentum is broad. Nine of the ten S&P 500 sectors have recorded a decrease in earnings growth rates since March 31 (telecom being the only slight exception).
- Earnings growth momentum is narrow. Only four out of ten sectors are expected to report earnings growth at all in 2Q 2012, including technology and financials. If you exclude Apple (AAPL) EPS for the technology sector is expected to contract YoY by -2.0%. And if you exclude Bank of America (BAC) EPS for the financials sector is expected to contract significantly. Industrials is another of the four sectors in which EPS growth is expected - but given global growth prospects going forward EPS growth in this sector is likely to go negative soon.
- Margin Pressure. Eight of the ten sectors in the S&P 500 index are projected to report higher revenue growth than earnings growth for 2Q 2012, which indicates that companies are experiencing margin pressure due to costs rising faster than revenues.
- Leading sector warnings. The most economically sensitive sectors are flashing the most ominous warning signs. Cyclical sectors such as energy and basic materials are expected to post the largest earnings declines (-19.3% and -11.9%, respectively). Furthermore, the consumer discretionary sector has posted the largest increase in negative earnings pre-announcements relative to all S&P sectors.
Consensus Earnings Expectations Completely Out of Whack
Despite the evident deterioration of earnings fundamentals, and the scramble to lower short-term earnings estimates, analysts as a whole have yet to revise their longer-term earnings estimates to reasonable levels.
12-month trailing S&P 500 earnings is now projected at $98.52 for 2Q 2012. Compare this to the current consensus EPS expectation of $111 for 2Q 2012. This 12.67% EPS growth rate between 2Q 2012 and 2Q 2013 is currently projected by the consensus despite low single digit YOY run rates for 2Q 2012 and 3Q 2013 - meaning that current expectations for 4Q 2012, 1Q 2013 and 2Q 2013 are entirely unreasonable (running in the high teens) and must eventually be revised downwards very substantially.
Given the sort of global economic slowdown that I expect in the second half of 2012 and the first half of 2012, I believe the trailing 12-month earnings figure for June 30 2013 is likely to be in the low 90s, (versus the 1Q 2012 trailing EPS figure of 98.12). My projection represents a modest YoY EPS contraction in the low single digit range. However, this represents a rather radical negative turn-around of about 20% relative to current EPS expectations. Furthermore, the current consensus expectation for full-year 2013 of $118 is more likely to fall below $90, which implies a YoY EPS contraction of around 10%-15%, but a negative turn-around of about 30% relative to current expectations.
Please note that my earnings estimates for the next 18 months assume only a major economic slowdown globally and in the US. A full-blown global recession in the US and/or globally would imply even lower EPS estimates.
The Causes of The Earnings Collapse
The US economy is not doing well. The US economy barely grew by 1.9% in the first quarter of 2012 - a rate of economic growth that historically has suggested at this stage of the economic cycle that a recession is imminent. To make matters worse, it is now clear that the US economy is decelerating at a very rapid pace in the second quarter of 2012 relative to the sluggish growth in 1Q 2012. Indeed, I expect that GDP growth will register well below 1.5% % in 2Q 2012 on its way to a possible date with sub-zero growth in 3Q 2012.
But sluggish US growth is only a small part of the story.
Most US investors have a very provincial mind-set. Few seem to grasp that well over 35% of S&P 500 revenue and near 50% of S&P 500 earnings come from non-US sources.
The rest of the world is decelerating at a much more dramatic rate than in the US. A major recession in Europe is now a virtual certainty. And expected growth rates from Asia to Latin America are being slashed to levels consistent with a "hard-landing" scenario.
As a global economic bellwether, S&P 500 earnings will reflect the impact of the global growth slowdown very dramatically. Not only will sales in sectors such as technology and consumer discretionary plummet (due to their high exposure to non-US markets), the earnings of energy and basic material companies will be devastated by a severe drop in globally priced commodities.
Many US investors seem to think that the crisis developing in Europe is simply "noise," and that US equity markets will continue to thrive in more or less a "business as usual" fashion.
I've got news for these folks: You need to bone up on what "business as usual" means these days for the S&P 500 and to realize that about half of S&P 500 business is outside the US. Nobody that understands the composition of S&P 500 earnings, and what is happening in the world at large, can possibly think that business will be "as usual" for the next 12-18 months. You can place your faith in global central banks and Faustian bargains to somehow bail out S&P 500 corporate earnings, but you cannot reasonably think that business for S&P 500 will be as usual.
2Q 2012 S&P 500 earnings will begin to reflect the pains from a slowing global economy. But this will just mark the beginning of the global slow-down and the hit to S&P 500 EPS. Analysts and investors are in for a nasty surprise in the quarters ahead when they get a real-life lesson in where S&P earnings come from and how business conditions are doing outside the US. S&P earnings are headed for a sharp contraction, and this will come as a shock to the financial market participants that are still expecting vigorous EPS growth for the S&P 500 for 2012 and 2013.
Right now, ignorance is bliss for the bulk of US stock investors, as foreign troubles seem remote and do not appear to yet be affecting their daily lives. However, knowledge of the impact of foreign affairs on S&P 500 earnings will soon become excruciating for stock market investors. Equity and equity index investors (SPY), (DIA) should beware.
Additional disclosure: Long VXX Calls.