EmailThe fourth quarter earnings reporting period will have its official start this week when Dow component Alcoa (AA) reports its results after the close on Tuesday, January 8. You wouldn't know it looking at the recent performance of the equity market, but earnings growth expectations are very low.
According to FactSet, aggregate fourth quarter earnings are projected to grow just 2.4%.
Excluding the financial sector, the projected growth rate slips to a bare bones 0.2%. When it comes to earnings, we don't like making such exclusions -- good or bad -- because it all counts in the end. It is clear, however, that earnings growth in general is skewed to the weak side of things.
Back to the Earnings Future
When we published our third quarter earnings preview on October 8, the fourth quarter consensus earnings growth estimate stood at 9.2%. We said then that the growth estimate was too high given the macroeconomic challenges and the debilitating political uncertainty.
Sure enough, analysts have been steadily slashing their earnings estimates, spurred in large part by numerous earnings warnings issued at the time of the third quarter reports. Separately, the first quarter earnings growth estimate has been cut to 2.5% from 5.3%.
FactSet indicates that 110 S&P 500 companies have issued fourth quarter guidance. Out of that total, 78 companies, or 71%, have issued negative guidance. That is well above the five-year average of 61%.
The information technology sector has been far and away the largest source of negative guidance. Of the 32 companies in the sector that issued guidance, 29, or 91%, issued negative guidance.
In the wake of those warnings, the projected growth rate for the information technology sector has gone from 8.4% on September 30 to a decline of 2.8% today, according to FactSet. Apple (AAPL) is a notable drag on the sector. Analysts are currently expecting the company to post its first quarterly decline in earnings ($13.44 vs. $13.87 year ago) in more than nine years.
Positive surprises can never be ruled out for Apple, although the company has come up short of consensus earnings estimates the last two quarters.
The table below shows a breakdown of growth estimates for all ten sectors compared to estimates seen at the start of the fourth quarter. The health care, information technology, and industrials sectors are the only sectors expected to experience an actual decline in earnings, yet their large weighting in the S&P 500 is dragging down the aggregate growth rate despite the 15.5% growth rate projected for the financials sector.
| Sector | September 30 | Today |
|---|---|---|
| Financials | 27.8% | 15.5% |
| Telecom Services | 7.9% | 10.3% |
| Utilities | 4.6% | 7.8% |
| Materials | 23.9% | 6.0% |
| Consumer Discretionary | 9.9% | 4.5% |
| Energy | 2.3% | 3.0% |
| Consumer Staples | 5.0% | 2.9% |
| Health Care | 1.9% | -2.6% |
| Information Technology | 8.4% | -2.8% |
| Industrials | 3.3% | -4.6% |
| S&P 500 | 9.2% | 2.4% |
New Quarter, Similar Headwinds
We're only three months removed from the third quarter earnings reports. Consequently, many of the same factors that contributed to a 0.9% decline in third quarter earnings remain present today.
- Economic conditions in the eurozone are weak.
- The fourth quarter average for the Fed's nominal broad effective exchange rate index was 1.9% higher than the prior-year period, signifying that the dollar's strength will remain an adverse factor in currency translation, albeit not as much as before.
- China's economy appears to be regaining some strength, but its fourth quarter growth will trail the 8.9% growth seen in the fourth quarter of 2011.
- Fiscal policy uncertainty was considerable.
- Businesses maintained a guarded stance with capital spending decisions.
- Earnings growth for consumers remained subdued.
On a better note, many companies should have gotten some measure of relief from lower oil prices, which averaged $88.29 per barrel in the fourth quarter versus $93.97 per barrel in the same period a year ago.
The offset here is that lower oil prices will weigh on the energy sector, which is projected to report a 10.5% decline in fourth quarter revenue. That decline will factor prominently in total revenue growth for the S&P 500, which is anticipated to be just 2.1% even though eight of the ten sectors are expected to report revenue growth, as seen in the table below.
Weak revenue growth continues to be a threat to profit growth since profits can only go up faster than revenue with an increase in profit margins -- and profit margins are already near record-high levels.
| Sector | September 30 | Today |
|---|---|---|
| Utilities | 6.6% | 12.5% |
| Financials | 2.6% | 7.0% |
| Health Care | 7.4% | 6.5% |
| Information Technology | 8.0% | 5.4% |
| Consumer Discretionary | 5.4% | 4.6% |
| Consumer Staples | 4.2% | 2.9% |
| Telecom Services | 2.0% | 1.8% |
| Industrials | 3.0% | 1.2% |
| Materials | 2.4% | -0.9% |
| Energy | -9.5% | -10.5% |
| S&P 500 | 2.7% | 2.1% |
What It All Means
As noted above, it was not a surprise to us to see the fourth quarter earnings growth estimate come down. It is a common practice for earnings estimates to get cut as the quarter winds down and analysts have a more complete view of things.
What often happens, though, is that analysts overshoot on the downside, thereby lowering the bar for companies to report positive earnings surprises. We suspect that will likely be the case again this quarter, particularly since the scope of the revision -- a 6.2% cut to the fourth quarter EPS estimate -- is ahead of the average 4.2% cut to the EPS estimate seen during a quarter over the past ten years, according to FactSet data.
While earnings growth estimates have come down sharply since the end of the third quarter, the stock market at the same time has increased in price. Since the end of the third quarter, the S&P 500 has increased 1.8%. That gain of course has been achieved entirely over the last four trading sessions.
It hasn't exactly been a move predicated on earnings optimism so much as it has been a move predicated on relief that the full force of the fiscal cliff was averted and the seasonal influence of institutions putting money to work at the start of a new year.
We suppose one could make a case that earnings optimism has played a role in the recent rally. After all, earnings prospects are better if an economy is not in a recession.
2013, however, should be a challenging year for earnings growth given the languid state of economic growth in much of the developed world. Given the Fed's influence, though, weak earnings trends seem to be mattering less than they would otherwise.
The fact of the matter now is that earnings trends aren't driving the market these days so much as what the Federal Reserve is doing, what Congress is doing (or not doing), what the ECB is doing, and what China is rumored to be doing.
The market is effectively spinning in a quick-rinse news cycle while earnings drip on the drying rack.
If they continue to drip, keep in mind that the floor of support the Fed has provided for the equity market could get slipperier, because earnings do indeed matter in the end.
