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The Consensus Earnings Estimate
The third quarter earnings reporting period is rapidly approaching. In fact, it is just days away if you consider Alcoa (AA) to be the grand marshal of the earnings parade.
The Dow component will release its quarterly results after the close on Wednesday, October 7; however, the real rush of earnings reporting doesn't begin until the week of October 12.
Readers will recall that the second quarter reporting period, which began in mid-July, coincided with the latest ramp in the stock market, which has seen the S&P 500 gain as much as 33% since the close on July 10.
A series of better-than-expected earnings reports juiced economic recovery expectations, which was a bit surprising since it was apparent that the earnings surprises were largely a byproduct of expense cuts, meaning end demand was still quite poor.
Sure, sales growth was found here and there, but remarkably, only 23% of the S&P 500 companies posting results reported year-over-year sales growth.
The latter point notwithstanding, 73% of the companies reporting second quarter results exceeded consensus earnings estimates. According to Thomson Reuters, that matched the highest rate of positive surprises since the first quarter 1994.
The impressive number of earnings surprises demonstrated two things: (1) corporate America was chubbier than most people thought, even after its first quarter expense diet and (2) analysts took perhaps the lowest road possible with their estimates, making it almost impossible for most companies not to beat expectations (according to Thomson Reuters, companies in aggregate reported earnings that were 13.5% above estimates versus a 1.7% long-term average surprise factor since 1994).
A Game of Expectations
Coming out of the second quarter reporting period, there is a risk now that expectations are too high, not necessarily for the companies themselves but for the stock market itself given how bullish the response was to the second quarter results.
There could be the same expectation that the market will gloss right over bad news, leaning on the assumption that easier comparisons should make for much better news in the fourth quarter and in the first quarter of 2010 given that GDP declined 5.4% and 6.4%, respectively, in the year-ago periods.
There will be a greater demand for top-line driven earnings growth in the third quarter reports, yet with the easy comparisons on the horizon, it is easy to see how the market could grant another hall pass to corporate America despite deficient sales growth.
The weakening dollar will be a supportive force in the earnings outlook for the fourth and first quarters, but we have to admit that we find the dollar to be increasingly enigmatic these days.
In the context of the recovery trade, we'd expect a better showing from the greenback. The fact that it is now being viewed as a funding currency for a carry trade (borrow in a low-yielding currency and invest in a higher-yielding one) is a bit unsettling, especially since the yen used to fit that bill -- and we all know how stellar the Japanese economy has been the last 20 years.
Setting our long-term dollar concerns aside, the weakening of the dollar is supportive to the earnings outlook for multinational companies and should be digestible as a market factor for the time being provided it continues in a gradual manner.
Less Doom than Before
Another point worth making is that analysts don't appear to be forecasting more gloom and earnings doom. On the contrary, things are looking up as far as consensus estimate trends are concerned. That is, they are primarily looking up on a forward 4 quarter and calendar year 2010 basis.
That's because it is evident in the economic data that the U.S. economy and the global economy, while not fully recovered, are showing signs of recovery after the near meltdown of the U.S. financial system.
Things aren't truly good yet from an economic standpoint, but clearly they are less bad than before. This understanding has fed the improved earnings outlook, which is reflected in the charts below.
These charts also paint a telling message that stocks and/or the market tend to follow the trend in the consensus estimate. That makes sense since earnings are the most important driver of stock prices.
What can be ascertained from the charts is that earnings estimates for calendar year 2010 started to pick up noticeably at the start of June, as did positive earnings revisions (a number below 1.0 reflects negative revision momentum while a number above 1.0 reflects positive revision momentum).
That also makes sense knowing that the government's stimulus spending will persist in 2010. Moreover, it has been presumed that the housing market, the auto industry, the banking sector, and the consumer will be in much better shape in 2010, certainly vis-a-vis 2009.
There is a lot of optimism about the 2010 earnings outlook -- and the forward 4 quarter outlook for that matter as easy comparison periods await. According to Thomson Reuters, the calendar year 2010 consensus EPS estimate of $75.50 stands 27% above the calendar year 2009 consensus estimate of $59.61.
Mind the Gap
What grabs our attention in the symbiotic relationship between estimate trends and the stock market bias is that there is a big gap that reflects a disconnect between analysts' outlook and the market's outlook. To that end, the consensus 2010 earnings estimate has risen 2.8% since the end of May while the S&P 500 has advanced 11.5%.
This wide gap suggests analysts are either still too pessimistic about earnings prospects or that the market is too optimistic.
It is likely that the right perspective is somewhere in the middle, which is why the forward 4 quarter estimate looks more plausible for acting as the denominator when calculating the market's P/E multiple (15.3x).
The world is still too uncertain a place to put full faith and credit in the calendar 2010 estimate. From our vantage point, we see earnings risk in the back half of 2010 -- when comparisons are more challenging -- since we continue to believe the consumer won't be in the robust shape the market is hoping he/she will be.
Our assumption is that the consumer will still be in a deleveraging mode where the aim is to save more and to spend less, and that a weak labor market will be a driving factor for that approach.
Taking this into account, it is our belief that the stock market has gotten ahead of itself with recovery expectations.
It is understandable why the stock market might still grind higher in the near-term. Easier comparisons play out well in liquidity-driven moves like the one we have seen since March.
Still, at 15.3x forward 4 quarter earnings, we think the stock market is fairly valued when contemplating a longer-term outlook that will inevitably include higher inflation, higher interest rates, higher tax rates, higher rates of unemployment, a higher level of savings, lower levels of borrowing, and increased regulation.
With this vision then, we are recommending investors favor quality companies with solid balance sheets as opposed to chasing the rally in crowded trades that always end badly when the mob decides to disburse.
Feeds!