EmailWith the week that just concluded, more than half of the members of the S&P 500 have now reported their earnings for the December quarter. As expected, the results in aggregate have been better than expected.
According to FactSet, the fourth quarter blended earnings growth rate, which includes reported actuals and estimates for companies that have not yet reported, is 3.0%. Prior to Alcoa's report on January 8, the projected growth rate was 2.4%.
The equity market has rallied strongly through the earnings reporting period, making it appear as if the market has liked what it has heard on the earnings front. That certainly rings true for some individual companies, but the truth of the matter is that the market has turned a deaf ear to weak earnings guidance and a blind eye to lowered earnings estimates.
That is a bit surprising for a forward-looking entity like the stock market. Then again, it is not surprising if one stops to consider that the price action suggests the stock market is basically looking past the first half of the year.
It is doing so with a yearning for good economic and earnings news in the second half of the year and a guiding belief that nothing bad will come to pass in the interim.
It is a defensible position given the growth pickup in China, the enduring liquidity support provided by the world's leading central banks, and the history of eleventh-hour policy solutions in Europe and the US. At the same time, though, it is an increasingly risky position as the March 1 sequestration deadline draws near.
Financials and Energy Drive Q4 Earnings Growth
As discussed in our fourth quarter earnings preview on January 7, the financial sector has been the main driver behind the fourth quarter earnings growth. The energy sector, however, has been a surprising swing factor, delivering earnings growth that has been much better than expected.
Positive earnings surprises out of Chevron (CVX), ExxonMobil (XOM), and Valero (VLO) in particular have helped drive the fourth quarter earnings growth rate for the energy sector to 9.0% from 3.0% at the time of our preview.
The table below provides a snapshot of sector earnings growth for the fourth quarter versus a year ago and reveals how growth expectations have changed since early January.
| Sector | January 7 | Today |
|---|---|---|
| Financials | 15.5% | 14.3% |
| Materials | 6.0% | 10.3% |
| Utilities | 7.8% | 10.0% |
| Energy | 3.0% | 9.0% |
| Consumer Discretionary | 4.5% | 5.9% |
| Consumer Staples | 2.9% | 4.3% |
| S&P 500 | 2.4% | 3.0% |
| Information Technology | -2.8% | 0.4% |
| Health Care | -2.6% | 0.4% |
| Telecom Services | 10.3% | -9.9% |
| Industrials | -4.6% | -16.8% |
Aside from the better than expected earnings, revenue growth has also surprised on the upside. According to FactSet, 67% of the companies reporting revenues have exceeded expectations versus a lowly average of 41% over the previous two quarters.
Companies in aggregate are reporting revenues that are 1.8% above expectations. The fourth quarter revenue growth rate, which was forecast to be up 2.1% on January 7, now stands at 3.8%.
Once again, the energy sector factors prominently in this tabulation. It is the only sector on pace to see revenues decline versus a year ago, yet that distinction comes with an asterisk.
Sector revenues in 4Q11 included Phillips 66 revenues in the total for ConocoPhillips. Phillips 66 is no longer included in ConocoPhillips's revenue. According to FactSet, the revenue growth rate for the energy sector improves to 0.2% if ConocoPhillips is excluded from the mix.
The table below shows a revenue growth breakdown by sector versus a year ago and where estimates stood on January 7.
| Sector | January 7 | Today |
|---|---|---|
| Financials | 7.0% | 18.6% |
| Health Care | 6.5% | 8.0% |
| Utilities | 12.5% | 6.9% |
| Information Technology | 5.4% | 5.1% |
| Consumer Discretionary | 4.6% | 4.8% |
| S&P 500 | 2.1% | 3.8% |
| Telecom Services | 1.8% | 3.0% |
| Consumer Staples | 2.9% | 2.9% |
| Industrials | 1.2% | 1.9% |
| Materials | -0.9% | 0.1% |
| Energy | -10.5% | -9.2% |
Just Wait Six Months
The fourth quarter is history. Some familiar themes included a recognition that currency translation was a negative factor for many multinational companies, that growth in China is improving, that Europe remains weak, and that fiscal uncertainty in the US has impeded spending.
Another familiar theme is that many companies are expecting things to be better in the second half of 2013. That was not surprising to hear in the sense that it has become standard fare to suggest things will look better six months down the road.
That mentality is the basis for why consensus earnings growth estimates several quarters out always look good, especially in a bull market -- and then almost always get revised lower when the future becomes the present. To wit, the consensus fourth quarter earnings growth estimate stood at 14% on July 1. Today, the market is cheering "better than expected" fourth quarter growth of 3.0%.
Earnings estimates more than two quarters out are basically meaningless. On that note, the consensus earnings growth estimates compiled by Thomson Reuters for the third and fourth quarters are 10% and 14%, respectively.
That is hockey-stick forecasting indeed given that the earnings growth estimate for the first quarter has been slashed to 0.1% from 2.4% while the second quarter growth estimate has been reduced to 5.1% from 6.7% since the start of the year, according to FactSet.
The downward revisions have coincided with weak corporate guidance for the first quarter -- not that it has registered for a market trading on the expectation of a second half rebound.
According to FactSet, 80 companies have issued guidance for the first quarter. Out of that total, 63 companies, or 79%, have issued negative guidance. That is well ahead of the five-year average of 61%.
An Elusive Compromise
The first quarter earnings reports could be full of surprises depending on what happens in the discussions leading up to the March 1 sequestration deadline. That is when automatic spending cuts are due to start under a plan legislated in the Budget Control Act to reduce projected deficits by $1.2 trillion over the next 10 years.
This plan was borne out of the debt ceiling negotiations of 2011. It was presumed that the severity of the spending cuts (50% for defense and 50% for domestic discretionary spending) would produce a bipartisan compromise to cut spending in a less onerous way for the US economy.
Such a compromise has remained elusive. The only bipartisan agreement on the sequester so far has been to extend the implementation date from January 1 to March 1. That agreement was struck in conjunction with the deal on tax rates at the start of the year.
There are forecasts indicating as many as 1 million jobs could soon be lost if the sequestration takes place.
The Congressional Budget Office recently released a report in which it estimated real GDP growth will be a meager 1.4% in 2013 if the fiscal tightening occurs under current law. Furthermore, the CBO is projecting a bump in the unemployment rate from 7.8% to 8.0% in the fourth quarter of this year.
Unappreciated Risk
These dour predictions are turning up the heat on Congress and President Obama to reach a spending deal that averts the blunt-force trauma of sequestration to the US economy. So far, that has not happened... and the clock is definitely ticking.
President Obama recently proposed passing a short-term budget plan that allows for more time to consider spending cuts AND added sources of revenue. Republicans lambasted the idea of finding more ways to raise revenue (i.e. raise taxes). Many GOP members frankly are just fine with the spending cuts taking place as designed.
The stock market has been unbowed by the partisan bickering, because past experience has allowed it to place faith in the idea that a deal will get done that avoids the worst-case scenario. It may not be a pretty deal and it may not come until the last minute, but a deal will get done -- or so it is thought.
The stock market may ultimately be proven right, but the Republicans have a lot of party ideology tied up in the sequestration. They want spending cuts in a big way -- and soon -- to keep the national debt from exploding further. The sequestration is a legally binding step in that direction and they know it can be taken without any further action on their part.
This is a roundabout way of saying that there is a considerable, and unappreciated, risk right now that a kumbaya agreement won't be struck on the sequestration.
With a 6.4% rally since the start of the year, the stock market is absolutely not priced for that potential disappointment.
What It All Means
The stock market is on a tear right now and the support of the Fed's easy-money policy has a lot to do with it. Many pundits see that policy as the one constant that trumps all else, because it is seen as buying time for the real economy to catch up to the stock market.
If the sequestration kicks in as it is currently designed to do, the earnings and growth momentum the market is yearning for and expecting in the second half of the year is unlikely to materialize.
That thought is not on the mind of a market that has been blind to lowered earnings estimates, deaf to earnings warnings, and quiet about the sequestration actually happening.
Others are busy these days singing the praises of rising stock prices. We appreciate that chorus, but we have also been preaching the hymn of risk management in a market that effectively sees no evil, hears no evil, and speaks no evil.
The sequestration holds the potential to be an evil thing for investors simply because the stock market has no appreciation for the real risk of it happening.
Be careful.
