Investors should always keep a careful eye trained on US and global economic conditions. But the fundamentals that ultimately move stocks are corporate profits and sales.
One of the most persistent bearish arguments against equities in recent quarters has been that although companies have been able to beat earnings expectations, most of that upside was driven by cost-cutting. Of course, one of the most common ways companies cut costs is to lay off workers when demand slumps; the surge in the US unemployment rate over the past two years is a sure sign firms are doing just that.
By cutting labor costs firms have boosted profit growth even though demand has remained weak. This technique is only useful to a point. Early in a downturn it’s relatively easy to trim fat, but at some point it becomes hard to make additional cuts without effecting long-term competitiveness. Cost-cutting frequently drives a recovery in corporate profits early in a cyclical upturn, but ultimately it’s unsustainable--firms need to see actual growth in demand to drive earnings.
The most common proof of this case: Although companies have beaten profit expectations, revenue growth has remained weak. Sales growth offers a better picture of actual end-market demand than earnings, and sales are far harder to “manage” with accounting tricks and obfuscations.
But this bear case is crumbling. Check out the table below, which details earnings and revenue results released so far this season.
Nearly three-quarters of the companies represented in the S&P 500 have reported fourth-quarter results as of February 12. Of that total, 75.7 percent have beaten consensus analyst earnings estimates heading into the quarter. Average earnings growth is close to 47 percent, an impressive figure in any historical context.
However, what’s really different this quarter is that most stocks are also beating sales estimates. Close to 70 percent of S&P 500 stocks have beaten on the top line, and the average revenue growth rate for the quarter is 7.4 percent.
Also note that I’ve broken out results for each of the 10 official S&P economic sectors. Strength on both the revenue and earnings lines is broad-based, with almost all sectors showing better-than-expected growth. Only three economic sectors have posted negative earnings growth this quarter, and just two are still seeing shrinking revenues.
Particularly notable this quarter is the strong showing from the Information Technology and Health Care industries. Outside of financials, these two groups are showing the strongest revenue growth rates. And in both cases well over 80 percent of reporting firms have beaten expectations.
Commentary and guidance from IT firms was particularly upbeat. This is reflected in the fact that analysts have been steadily boosting earnings and sales estimates for 2010 and 2011 as earnings season has progressed. For the S&P 500 Information Technology Index, analysts’ earnings estimates for 2010 are up 5.5 percent over the past four weeks alone, and sales estimates are up 3.4 percent. Also helping IT is that the sector has significant leverage to markets outside the US, where demand has been quicker to bounce back.
Remarks by the largest technology firms suggest enterprise spending is snapping back this year. Businesses cut back on buying new IT products during the 2007-09 downturn in an effort to cut costs.
These firms have under-spent on technology upgrades in areas as wide-ranging as software, PCs, networking equipment and IT security. Companies will now need to play catch up to keep their systems up to date and to keep pace with the projected growth in Internet traffic in coming years--the amount of data traveling across the Internet is projected to roughly quadruple between 2009 and 2013.
Another factor driving technology spending is the release of Microsoft’s (NSDQ: MSFT) Windows 7 operating system (OS). Microsoft’s Vista, released globally in early 2007, was widely panned, and many corporate buyers simply stuck with the company’s older XP software.
But Windows 7 has received better reviews, and the early adoption rate for the new OS is far faster than for Vista. In its recent quarterly conference call Microsoft noted that by the end of 2009 it had already sold 60 million Windows 7 licenses, making it the fastest-growing operating system in history. Microsoft also plans the release of its new Office suite of word processing, presentation and spreadsheet software later this year.
The release of new Windows operating systems is often a catalyst for companies to upgrade their equipment. Because companies opted not to upgrade to Vista, there’s even more pent-up demand than in most cycles.
Another firm to watch as a gauge of enterprise IT spending is Cisco Systems (NSDQ: CSCO), a market leader in networking products such as routers and switches. And, thanks to a spate of acquisitions over the past year, Cisco has also entered a variety of new markets, including network security, software and services.
Cisco management was upbeat during its recent conference call. The company beat expectations for the most recent quarter and guided analyst expectations for 2010 revenue and earnings sharply higher. Management also noted it was seeing broad-based strength across its product lines and all geographic areas; because enterprise customers are Cisco’s bread-and-butter, this suggests that IT budgets are loosening.
Amid the positive backdrop of better-than-expected earnings reports and the return of actual revenue growth, investors are likely wondering why the market has endured a correction of roughly 10 percent from January highs to recent lows. And though the IT sector is showing some of the strongest fundamental performance of all, it remains among the worst-performing groups in the S&P so far this year.
The rally in the broader market averages late last year reflected growing expectations for stronger corporate profits in the fourth quarter. Although companies are beating published consensus estimates, some of these better-than-expected results were likely already priced into shares. Technology stocks were among the best performers in 2009, so it’s only natural that they’d now be seeing a more severe correction than your average S&P 500 stock this year.
More broadly, I continue to believe the US market is in the midst of a classic growth scare. Economic data rarely uniformly points in the same direction, and recoveries never proceed at a steady, uninterrupted pace. Weaker-than-expected US and EU economic data early in 2010 coupled with fears of a Chinese slowdown prompted by government tightening have raised fears that the global economic recovery is stalling.
We’ve seen this before. Last summer a spate of weaker economic data prompted a correction in the S&P 500. And back in 2004 the market was range-bound for much of the year over fears the US economic recovery was faltering. The fact that investors are looking to take profits after a big run-up just adds fuel to the pullback.
My take remains that investors are largely too pessimistic about the next 12 to 18 months. There’s no sign yet of concerted weakness in US economic data, and the US Leading Economic Index (NYSEMKT:LEI), one of my favorite quick measures of US economic health, continues to point to a strengthening recovery. Furthermore, the data from individual companies in a wide variety of sectors remains positive as I outlined above.
As my colleague Yiannis Mostrous points out, investors’ fears of a major economic slowdown in key emerging markets such as China and India are overblown.
Corrections of 10 to 15 percent for the S&P 500 are common in the context of a broader market rally. This means there could be some additional downside for the averages short term. But I see this as a buying opportunity, not reason to sell.
Disclosure: "No Positions"