EmailThe Big Picture
Archive
Last Update: 23-Jul-12 08:30 ET
The Best of Earnings Is Over, and It Wasn't That Great
Second quarter earnings reports aren’t as good as they appear. Profit growth is near zero outside of the financial sector, and revenue growth is extremely disappointing. The largest companies in the sectors that will post the strongest earnings have already reported. Less exciting reports from weaker sectors are now on tap, and the market focus will therefore shift to worrisome macroeconomic trends.
Earnings Analysis
Second quarter earnings to date have not been as good as press reports suggest.
Through Friday, 110 (22%) of the S&P 500 companies had reported. Approximately 67% had beaten the average Wall Street forecast.
That seems good, but it is only the result of earnings forecasts coming down sharply in June. A look at the absolute numbers reveals two disturbing trends.
First, earnings excluding the financial sector are on track to post a decline of 1%. The broad trend in earnings is very weak, and even the earnings strength in the financial sector is unimpressive.
The financial sector will post an earnings gain of over 50%. That is simply because a number of banks took large charges in the second quarter last year. The improvement in earnings compared to last year does not reflect a sustainable underlying trend. That is why the sector has not gotten a boost from earnings reports.
Since reporting, Bank of America is down 11%, Citigroup is down 3%, Goldman Sachs is down 4%, JP Morgan Chase is down less than 1%, and Morgan Stanley is down 9%. Wells Fargo is bucking the trend with a stock price gain of 3%.
The top stocks in the sector with the highest growth haven’t gotten a boost from earnings.
The S&P 500 is up ten points since the start of the earnings reports, but it is hard to expect the upcoming earnings reports, which will run at near-zero growth for the quarter, to provide the impetus for a late summer rally.
The second disturbing trend is in the revenue numbers. To date, approximately 57% of companies have reported revenue below forecasts. That is terrible.
Total revenue for the quarter is on track for only 1% growth.
That should be raising red flags. Companies can manage (manipulate) earnings in any given quarter to beat analyst estimates, but they can’t do that with revenue. The revenue misses indicate that underlying company fundamentals are worse than expected, and the 1% lackluster trend augurs poorly for earnings for the rest of this year.
Profit margins are already at historically high levels, and the overall 6% earnings growth coupled with 1% revenue growth means that companies are stretching even further to post current profit growth. This can’t continue.
Current revenue projections for the S&P 500 for the third quarter are at just 2%, and that could come down as more companies report disappointing second quarter numbers and present cautious outlooks. Fourth quarter revenue estimates are near 4%, but that may be a stretch.
That rate of revenue growth simply can’t produce significant profit growth in upcoming quarters given how hard it will be to raise profit margins any further.
If margins simply hold steady, profit growth will match lackluster revenue growth. If margins get squeezed by higher commodity prices, sluggish revenue growth trends could result in a decline in overall profit levels.
And the ever-optimistic Wall Street analysts might already be too high on third and fourth quarter revenue estimates.
Furthermore, those estimates might need to be lowered given worrisome global economic trends. But first, the market has to contend with an uninspiring calendar of earnings reports the next few weeks.
The Earnings Calendar Turns Dull
Most of the best market-moving news from earnings may already be out. Only 22% of the S&P 500 has reported, but 11 (55%) of the top 20 market cap stocks have reported, including key reports with the ability to boost the broader market.
In technology, which has had generally good earnings reports that have provided support to the overall market, four of the six companies in the top 20 market cap stocks have reported. Google, Intel, IBM, and Microsoft are out. All beat earnings estimates. Apple comes out this week and Oracle in September. There aren’t many other tech reports that will have broad market impact.
The two banks in the top 20 market cap stocks (Wells Fargo and JP Morgan) have already reported, and, as noted above, even the financial sector hasn’t gotten a boost from those key reports.
The financial and technology sectors are the two sectors that will post the strongest earnings growth this quarter, and the best reports from those sectors are already out.
The earnings reports the next few weeks will be mostly from sectors that are expected to post mediocre earnings gains. The consumer discretionary (3% aggregate earnings growth), consumer staples (2%), health care (0%), telecom (1%), energy (-15%), and utility (-16%) sectors will all post very weak revenue and earnings numbers. These reports usually don’t have as much broad market impact as the financial or tech companies in any case, and will probably have even less impact this quarter given the anemic trends.
The kick from earnings reports will fade in the weeks ahead. The market chatter will move to global economic trends and the continuing crisis in Europe.
Economic Concerns
US economic trends are weakening.
Second quarter real GDP will be reported on Friday. Expectations are for an increase at just a 1.2% annual rate. That would be down from the anemic 1.9% annual rate of growth for GDP in the first quarter.
Furthermore, the outlook for the second half of the year is worsening. Consumer spending and business investment trends are weakening, and there is little sign of a turnaround.
The global outlook is of as much concern. Europe has been off the market radar the past two weeks because of earnings reports, but conditions there have worsened and could soon impact the US market.
It is widely reported and needs little explication here that growth is slowing in China, and that Spain is beset by recessionary forces which are now being compounded by spiking interest rates.
The salient issue is that the US equity markets have ignored these factors recently; but economic concerns will re-emerge soon enough. Talk of a recession in the US is even likely to become fashionable again.
And politics may make matters worse.
Tax Issues
In addition to the weak underlying economic trends, the markets will also have to face the very real prospect of turmoil from political gridlock as the January 1 fiscal cliff approaches.
If Congress and the president don’t act by the end of this year, there will be large tax increases (as income and social security tax cuts expire) and $1.2 trillion in spending cuts that the CBO says will throw the US into recession.
There is a risk of total political gridlock that leads to the full fiscal cliff; but even if there is a compromise on income tax rates and spending, there is still a chance of changes in tax laws that threaten to hammer the US stock market.
President Obama’s 2013 budget calls for the tax rate on dividends to rise from the current 15% to income tax rates (39.6% for high income earners). If planned phase-outs of deductions and exceptions take hold, and the investment tax surcharge for the Affordable Care Act is included, the dividend tax rate could reach nearly 45% for some people. Senate Democrats this week proposed a smaller increase to 20%. Republicans are opposed to raising the tax.
The long-term capital gains tax rate will rise to 20% next year from the current 15% if no action is taken. President Obama and the Senate Democrats support allowing the tax rate to rise to 20%. Republicans oppose raising the tax.
Any increase in either the dividend tax rate or the capital gains tax will decrease the value of stocks, particularly those that pay a high dividend yield. It is very hard to predict how the politics will play out, but even a small increase in taxes on equities will have a significant mathematical impact on valuations.
What It All Means
Stay defensive.
The market has been propped up recently on the traditional earnings season support as a result of most companies beating Wall Street forecasts.
The earnings reports, however, haven’t been as good as advertised. Upcoming reports will be worse. Revenue trends are very weak and sluggish global economic trends threaten to lead to lowered earnings expectations for the rest of the year.
The market focus will soon move from earnings to macroeconomic issues, and that increases downside stock market risk.
(Quantitative easing could help the stock market through the end of the year, but should not be seen as the final determinant of the stock market outlook. Next week’s Big Picture column will examine the potential impact of another round of quantitative easing.)
The S&P 500 is up 8.3% so far this year. It has been a good year. There is still excellent long-term value in stocks, as was emphasized in the July 2 Big Picture. The problem is that the current trends in the fundamentals suggest it might take a little longer than originally expected to realize that value.
--Dick Green
Founder and Chairman, Briefing.com
Earnings Analysis
Second quarter earnings to date have not been as good as press reports suggest.
Through Friday, 110 (22%) of the S&P 500 companies had reported. Approximately 67% had beaten the average Wall Street forecast.
That seems good, but it is only the result of earnings forecasts coming down sharply in June. A look at the absolute numbers reveals two disturbing trends.
First, earnings excluding the financial sector are on track to post a decline of 1%. The broad trend in earnings is very weak, and even the earnings strength in the financial sector is unimpressive.
The financial sector will post an earnings gain of over 50%. That is simply because a number of banks took large charges in the second quarter last year. The improvement in earnings compared to last year does not reflect a sustainable underlying trend. That is why the sector has not gotten a boost from earnings reports.
Since reporting, Bank of America is down 11%, Citigroup is down 3%, Goldman Sachs is down 4%, JP Morgan Chase is down less than 1%, and Morgan Stanley is down 9%. Wells Fargo is bucking the trend with a stock price gain of 3%.
The top stocks in the sector with the highest growth haven’t gotten a boost from earnings.
The S&P 500 is up ten points since the start of the earnings reports, but it is hard to expect the upcoming earnings reports, which will run at near-zero growth for the quarter, to provide the impetus for a late summer rally.
The second disturbing trend is in the revenue numbers. To date, approximately 57% of companies have reported revenue below forecasts. That is terrible.
Total revenue for the quarter is on track for only 1% growth.
That should be raising red flags. Companies can manage (manipulate) earnings in any given quarter to beat analyst estimates, but they can’t do that with revenue. The revenue misses indicate that underlying company fundamentals are worse than expected, and the 1% lackluster trend augurs poorly for earnings for the rest of this year.
Profit margins are already at historically high levels, and the overall 6% earnings growth coupled with 1% revenue growth means that companies are stretching even further to post current profit growth. This can’t continue.
Current revenue projections for the S&P 500 for the third quarter are at just 2%, and that could come down as more companies report disappointing second quarter numbers and present cautious outlooks. Fourth quarter revenue estimates are near 4%, but that may be a stretch.
That rate of revenue growth simply can’t produce significant profit growth in upcoming quarters given how hard it will be to raise profit margins any further.
If margins simply hold steady, profit growth will match lackluster revenue growth. If margins get squeezed by higher commodity prices, sluggish revenue growth trends could result in a decline in overall profit levels.
And the ever-optimistic Wall Street analysts might already be too high on third and fourth quarter revenue estimates.
Furthermore, those estimates might need to be lowered given worrisome global economic trends. But first, the market has to contend with an uninspiring calendar of earnings reports the next few weeks.
The Earnings Calendar Turns Dull
Most of the best market-moving news from earnings may already be out. Only 22% of the S&P 500 has reported, but 11 (55%) of the top 20 market cap stocks have reported, including key reports with the ability to boost the broader market.
In technology, which has had generally good earnings reports that have provided support to the overall market, four of the six companies in the top 20 market cap stocks have reported. Google, Intel, IBM, and Microsoft are out. All beat earnings estimates. Apple comes out this week and Oracle in September. There aren’t many other tech reports that will have broad market impact.
The two banks in the top 20 market cap stocks (Wells Fargo and JP Morgan) have already reported, and, as noted above, even the financial sector hasn’t gotten a boost from those key reports.
The financial and technology sectors are the two sectors that will post the strongest earnings growth this quarter, and the best reports from those sectors are already out.
The earnings reports the next few weeks will be mostly from sectors that are expected to post mediocre earnings gains. The consumer discretionary (3% aggregate earnings growth), consumer staples (2%), health care (0%), telecom (1%), energy (-15%), and utility (-16%) sectors will all post very weak revenue and earnings numbers. These reports usually don’t have as much broad market impact as the financial or tech companies in any case, and will probably have even less impact this quarter given the anemic trends.
The kick from earnings reports will fade in the weeks ahead. The market chatter will move to global economic trends and the continuing crisis in Europe.
Economic Concerns
US economic trends are weakening.
Second quarter real GDP will be reported on Friday. Expectations are for an increase at just a 1.2% annual rate. That would be down from the anemic 1.9% annual rate of growth for GDP in the first quarter.
Furthermore, the outlook for the second half of the year is worsening. Consumer spending and business investment trends are weakening, and there is little sign of a turnaround.
The global outlook is of as much concern. Europe has been off the market radar the past two weeks because of earnings reports, but conditions there have worsened and could soon impact the US market.
It is widely reported and needs little explication here that growth is slowing in China, and that Spain is beset by recessionary forces which are now being compounded by spiking interest rates.
The salient issue is that the US equity markets have ignored these factors recently; but economic concerns will re-emerge soon enough. Talk of a recession in the US is even likely to become fashionable again.
And politics may make matters worse.
Tax Issues
In addition to the weak underlying economic trends, the markets will also have to face the very real prospect of turmoil from political gridlock as the January 1 fiscal cliff approaches.
If Congress and the president don’t act by the end of this year, there will be large tax increases (as income and social security tax cuts expire) and $1.2 trillion in spending cuts that the CBO says will throw the US into recession.
There is a risk of total political gridlock that leads to the full fiscal cliff; but even if there is a compromise on income tax rates and spending, there is still a chance of changes in tax laws that threaten to hammer the US stock market.
President Obama’s 2013 budget calls for the tax rate on dividends to rise from the current 15% to income tax rates (39.6% for high income earners). If planned phase-outs of deductions and exceptions take hold, and the investment tax surcharge for the Affordable Care Act is included, the dividend tax rate could reach nearly 45% for some people. Senate Democrats this week proposed a smaller increase to 20%. Republicans are opposed to raising the tax.
The long-term capital gains tax rate will rise to 20% next year from the current 15% if no action is taken. President Obama and the Senate Democrats support allowing the tax rate to rise to 20%. Republicans oppose raising the tax.
Any increase in either the dividend tax rate or the capital gains tax will decrease the value of stocks, particularly those that pay a high dividend yield. It is very hard to predict how the politics will play out, but even a small increase in taxes on equities will have a significant mathematical impact on valuations.
What It All Means
Stay defensive.
The market has been propped up recently on the traditional earnings season support as a result of most companies beating Wall Street forecasts.
The earnings reports, however, haven’t been as good as advertised. Upcoming reports will be worse. Revenue trends are very weak and sluggish global economic trends threaten to lead to lowered earnings expectations for the rest of the year.
The market focus will soon move from earnings to macroeconomic issues, and that increases downside stock market risk.
(Quantitative easing could help the stock market through the end of the year, but should not be seen as the final determinant of the stock market outlook. Next week’s Big Picture column will examine the potential impact of another round of quantitative easing.)
The S&P 500 is up 8.3% so far this year. It has been a good year. There is still excellent long-term value in stocks, as was emphasized in the July 2 Big Picture. The problem is that the current trends in the fundamentals suggest it might take a little longer than originally expected to realize that value.
--Dick Green
Founder and Chairman, Briefing.com
