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Talley Leger
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Talley Léger is the founder and investment strategist of Macro Vision Research (MVR), a trusted source of objective, independent, thematic, macro research. MVR’s mission is to add value to institutional investors’ decision-making processes by generating creative portfolio themes and actionable... More
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  • S&P 500 Earnings Surprises Revert To Their Mean 5 comments
    May 6, 2012 7:42 PM | about stocks: SPY, XLY, XLP, XLE, XLF, XLV, XLI, XLB, XLK, XLU, XTL

    We've seen significant positive surprises so far this earnings season. Among the 60% (300) of S&P 500 companies that have reported with full comparable operating earnings per share (NYSEARCA:EPS) for 1Q12, 70% (210) beat, 19% (56) missed, and 11% (34) met their estimates (figure 1). Despite these considerable upside surprises, the S&P 500 is down -0.4% on a month-to-date basis. With the exception of Utilities (25%), at least 52% of firms have reported in each of the nine remaining sectors. 87% of Materials issues have beaten estimates, yet the sector is down -0.3% month to date. Curiously, 75% and 74% of Industrials and Technology companies, respectively, have come in better than expected but the segments are down -0.3% and -1.1%, each, in the same timeframe (figure 6). Why is there such a disconnect between the surprise to consensus sell-side earnings estimates and share price performance?

    Figure 1: Among the 60% of S&P 500 companies that have reported operating EPS for 1Q12, 70% beat, 19% missed, and 11% met their estimates

    (click to enlarge)EPS Beats Misses Meets

    Figure 2: Mean reversion - the beat rate has moderated to 70% (as of April 26)

    (click to enlarge)Mean Reversion

    Last week, we noted that this quarter's beat rate of 80% (as of April 19) was unusually high compared to the five-year average of 67%, just as last quarter's beat rate of 49% (as of January 19) was unusually low at the same point in the reporting period (figure 2). The major difference is that 1Q12 earnings estimates declined enough over the last several months for the actuals to be able to beat the estimates. However, Q1 estimates stopped decreasing on March 18 and have started increasing, meaning further significant positive surprises may be harder to come by (read: mean reversion). Indeed, the beat rate has moderated from 80% to 70% (as of April 26).

    We've always questioned the efficacy of earnings surprise models. To us, it seems the surprise says more about the instability of the estimates than it does about the underlying trend in earnings. In our view, it's the trend in earnings growth that matters most for equity returns. Figure 3 shows the year-over-year percent change on S&P 500 trailing 12-month operating EPS alongside the year-over-year percent change on the S&P 500 index since 1990. On a trend basis, equity returns usually benefit from accelerating earnings growth, and generally suffer from slowing earnings growth. S&P 500 quarterly operating EPS grew 16.4% y/y in 1Q11. So far, EPS are growing 7.8% y/y in 1Q12 according to Capital IQ's bottom-up consensus estimate (figure 4). The point we're trying to make is earnings support is waning for stocks on a trend basis.

    Figure 3: On a trend basis, equity returns usually benefit from accelerating earnings growth, and generally suffer from slowing earnings growth

    (click to enlarge)SPX EPS Long

    Figure 4: So far, EPS are growing 7.8% y/y in 1Q12, meaning earnings support is waning for stocks on a trend basis

    (click to enlarge)SPX EPS Short

    Last spring, we had a "minor" Greek tragedy while Euro Area real GDP grew 0.8% q/q in 1Q11. This spring, we have a major Spanish and Italian Inquisition while Euro Area real GDP entered recession for the second time since the start of the financial crisis, falling -0.3% q/q in 4Q11 and the momentum isn't looking good for 1Q12 (figure 5). Last week, we learned that the Markit Flash Eurozone PMI Composite Output Index (a weighted average of the Manufacturing PMI Output Index and the Services PMI Activity Index) dropped from 49.1 in March to 47.4 in April. This week, we learned that Spain (the fifth largest economy in Europe) real GDP shrank -0.3% q/q in 1Q12. Meanwhile, Standard & Poor's has downgraded 11 banks, including Santander (STD) and BBVA (NYSE:BBVA), adding to its two-notch downgrade of Spanish sovereign debt last week.

    As we noted last week, these trends bode ill for S&P 500 companies' global sales. Based on the 50% of S&P 500 companies with full reporting information, foreign or non-U.S. sales represented 46% of global sales in 2010. Importantly, Europe represented 29% of foreign sales, which means the region accounted for 13% of global sales, the second-largest category after that nebulous "Foreign Countries" bucket. Of those U.S. firms that do report foreign sales, few are required to specify where they're derived. When a U.S. company reports foreign sales but doesn't provide a breakdown, it gets thrown into the "Foreign Countries" category. The bottom line is there could be more European exposure in that general bucket than U.S. firms specify. Caveat emptor.

    Figure 5: Euro Area real GDP fell -0.3% q/q in 4Q11 and Spain (the fifth largest economy in Europe) real GDP shrank -0.3% q/q in 1Q12

    (click to enlarge)Euro Area & Spain GDP

    Figure 6: S&P 500 Sector Performance (April 27, 2012)

    (click to enlarge)Sector Performance

    Talley D. Léger

    Investment Strategist

    (203) 940-0878

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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Comments (5)
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  • Talley Leger
    , contributor
    Comments (9) | Send Message
     
    Author’s reply » Please check out my new Instablog post:
    S&P 500 Earnings Surprises Revert To Their Mean
    (http://seekingalpha.co...).
    1 May 2012, 01:10 PM Reply Like
  • Dibber
    , contributor
    Comments (1361) | Send Message
     
    Hey Talley,
    Just found this piece. Well done. I enjoyed it. Earnings definitely tend to mean revert to the 7% growth line, which explains the rapid growth in earnings in 2010 and 2011. We are back on that line now, so I would expect earnings to grow at about 7% going forward. Of course the real question is what sort of multiple should we put on that earnings stream, but that's a question for another day!
    -Dibber
    9 Jun 2012, 06:56 AM Reply Like
  • Talley Leger
    , contributor
    Comments (9) | Send Message
     
    Author’s reply » Thanks for reading, Dibber. Glad you enjoyed it. Agreed on multiples. Typically, there's been an inverse relationship between the level of earnings and multiples. If earnings keep growing at a trend pace, I wouldn't be surprised to see some modest multiple compression.

     

    Talley
    9 Jun 2012, 11:41 AM Reply Like
  • Dibber
    , contributor
    Comments (1361) | Send Message
     
    I hear you. Although multiples seem pretty compressed already, especially considering the current earnings environment...
    9 Jun 2012, 11:48 PM Reply Like
  • Talley Leger
    , contributor
    Comments (9) | Send Message
     
    Author’s reply » It's possible we could see expanding multiples and falling earnings, but that usually happens during either a mid-cycle slowdown or a recession. Sorry to use the "R" word.
    10 Jun 2012, 09:09 AM Reply Like
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