Widespread Weakness Anticipated In Q2 Net Income

With the first quarter earnings season behind us, it is time to turn our attention to the second quarter. So far just a few firms have reported, all of which have May fiscal quarters. Not much that we can say yet about those firms (other than it was not a fun quarter at Lehman Brothers (LEH). However, let’s take a good close examination of the expectations for the second quarter. On a median EPS growth rate basis, it looks like an anemic quarter shaping up with growth of 6.9% versus the 9.1% growth we saw in the first quarter. Usually though, more companies post positive surprises than disappointments, so I would not be surprised if the actual number when all is said and done is similar to what we saw in the first quarter.

Energy is currently expected to win the growth derby, not exactly a shocking idea with oil currently hovering in the $135 a barrel area. Perhaps the bigger question is: Why isn’t the expected growth rate much higher than it is? After all, the price of crude has just about doubled since this time last year. Since it costs to get the oil out of the ground last year one would expect that gross profits would more than double as a result. The 19.7% year-over year growth in EPS for the sector looks very conservative to me.

Tech and Health Care are currently expected to win Silver and Bronze in the second quarter, with growth of 15.6% and 12.4%, respectively. Once again, the biggest expected loser in the quarter is expected to be the Financials, with half the firms seeing a drop in their EPS of over 11.1%.

Consumer Durables follows closely behind with an expected drop of 7.3%. Given that the bulk of the stimulus checks are being mailed out in May and June, it would not surprise me if the retailers in the sector do a little bit better than expected for the quarter. However, even if that is the case, the effect would be short lived. The expected rebound to 4.3% growth in the third quarter seems to reflect slower assumptions about the pace of stimulus check disbursements than has actually happened.

Some of the factors which should help median EPS growth are share repurchases, which even though it has slowed in recent months, will still reflect what happened last year. In addition to the extent that firms have large operations overseas, they should benefit from the currency translation effects of the weak dollar. In addition the weak dollar has also boosted those companies that export a substantial portion of their sales.

Total Net Income Growth

Total net income for the S&P 500 is expected to fall for the third straight quarter. However, the magnitude of the decline is expected to be less than we saw in either the first quarter or in last years’ fourth quarter. The blame for net income decline once again goes to the Financials, but so does the credit for a less severe decline than last quarter. Overall, total net income for the S&P 500 is expected to be 11.0% below the second quarter of 2007.

In the Financial sector, total net income is expected to be 46.8% lower. In both cases this marks a significant improvement over the first quarter when the overall S&P 500 was down by 16.7% and the Financials were down 81.1%.

The Consumer Discretionary sector is also expected to angling to be a significant contributor to the weakness, with total net income dropping 18.2%, just a slightly less bad performance than the 20.3% decline it posted in the first quarter. Three other sectors, Materials, Utilities and Telecom are expected to show negative growth for the quarter.

Energy is expected to be the only sector to post a double-digit gain in total net income for the quarter, with a rise of 13.6%, but even there, that is significantly slower growth than the 25.8% posted in the first quarter. Consumer Staples and Tech are the only other two sectors expected to even surpass the 5.0% growth mark.

Overall it is a picture of widespread earnings weakness for the quarter. The biggest question is the extent to which the Financials have already come out with all their dirty laundry over the last two quarters.

The Zacks Revisions Ratio

To help gauge the direction of the market, we take note of what analysts are thinking. By tallying their EPS changes, we can determine our revisions ratio. This ratio simply divides the total number of positive estimate revisions by the total number of estimate cuts. Thus, a high ratio is a bullish indicator and a low ratio is bearish. For the S&P 500 as a whole, a number below 0.80 or above 1.25 is generally significant. For individual sectors the distance from 1.0 should be greater for the numbers to be significant.

The revisions ratio for 2008 continues to trend down again, falling for the third straight week, after several weeks of improvement. It is now at 0.91, a reading that we generally consider neutral. It appears that the positive revisions in reaction to positive surprises running more than 2:1 over disappointments, have worked their way through the system. After all, first-quarter earnings are part of full year earnings, thus if a firm reports higher than expected earnings for the quarter, and the analyst does not raise his full year numbers by the amount of the beat, he is implicitly cutting his estimates for the rest of the year. However, if the earnings report was more than four or five weeks ago, those estimate revisions have fallen out of the four week running totals we monitor.

The ratio fell to 0.91 from 0.99 last week and 1.10 two weeks ago. The overall pace of estimate revisions is past the peak for this quarter. Over the last four weeks there have been 1,190 changes in estimates: 568 up and 622 down, down 14.3% from 1,388: 689 up and 699 down last week. The ratio of firms with rising mean estimates to falling mean estimates is 0.91, in line with the revisions ratio, and in neutral territory. Three sectors are solidly in positive territory, two in neutral and five in negative territory. Energy was far and away the strongest with close to four increases for every cut. Tech followed with slightly over two increases for each cut.

The Financials were once again in the cellar, with almost four cuts per increase. While estimate cuts in the sector were widespread, they were particularly acute in the investment banks like Lehman, Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS). Lehman reported earlier than expected and much worse than expected, while GS and MS are expected to report this week.

The 2009 revisions story is similar to the 2008 story, just slightly weaker. The revisions ratio is below 1.0, and continues to trend downwards, falling to 0.82, up from 0.88 last week, and 0.90 two weeks ago. We still consider that to be in neutral territory however, but getting awfully close to negative territory.

Virtually all the strength is in the Energy sector, with a revisions ratio of 4.33. Tech also put in a decent showing at 1.88, or almost two increases for every cut. The Energy sector accounted for almost one quarter off all estimate increases over the last four weeks, and less than five percent of the estimate cuts. It is worth highlighting some of the E&P names like Devon (NYSE:DVN), EOG (NYSE:EOG) and XTO (NYSE:XTO). In Tech, the PC manufacturers, Dell (NASDAQ:DELL) and Hewlett Packard (NYSE:HPQ) were particularly strong.

The revisions picture for the Financial sector is even worse for 2009 than it is for 2008, coming in at 0.20, or five cuts for every increase. Revisions like these will eat away at the robust earnings rebound seen for 2009 (unless 2008 gets cut faster). We do not seem to be getting out of the woods on the Financial sector front. While there is weakness throughout the sector, one of the worst areas seems to be Banks with big exposure to Ohio, such as Key (NYSE:KEY), Fifth Third (NASDAQ:FITB), National City (NYSE:NCC) and U.S. Bank (NYSE:USB).

The total number of revisions for the whole S&P 500 for 2009 is also well past its seasonal peak. There were a total of 1,042 revisions: 471 up and 571 down. This is down 10.0% from 1,158 (541 up and 617 down) last week. The ratio of firms with rising mean estimates to falling mean estimates is 0.92, somewhat stronger than the revisions ratio, but also a weak neutral.

Market Cap versus Total Earnings

When making investment decisions, growth should always be looked at in conjunction with how much you are paying for a stock. Thus, it makes sense to look at the total earnings expected for a sector, relative to that sector’s total market capitalization. This is basically a variation on looking at the P/E.

The chart below shows the share of total earnings for 2007, 2008 and 2009, as well as the share of total market capitalization for each sector (the final bar shown). Since the S&P 500 is a market cap weighted index, this is the same as its index weight. On the chart below, the difference between the sizes of the first three bars shows if a sector is gaining or losing “earnings share”. The difference between the final bar and the first three bars shows if the sector is selling for an above or below market P/E. If the final bar is smaller than the other bars, the sector is selling for a below market P/E. However, as opposed to just showing the sector P/Es, it also shows the relative importance of the sectors to the overall index.

For years, the Financials were the dominate force in the market, both in terms of market cap, and even more so in terms of total earnings. They have now been dethroned on both counts. Still, despite their current problems, the Financials are still a very significant influence on the market. However, it is now likely that they will lose the earnings crown this year to the Energy sector. Even with all the disasters in the sector, for 2007, the Financials accounted for 22.3% of the total net income for the S&P 500. In 2008, that is currently expected to decline to 15.7% before rebounding to 19.9% in 2009. However, in recent years the sector has accounted for well over a quarter of all earnings.

Energy has usurped the crown this year, with its earnings share climbing to 19.2% from 15.7% in 2007. However, analysts expect a Financials restoration next year, with the sectors share rebounding to 19.9% while Energy slips back to 17.4%.

On the market cap (and index weight) front, Tech overtook the Financials 17.1% to 15.0%. Energy, despite being the biggest expected earner for 2008, is only in third place when it comes to index weight at 14.5%. Given the ongoing estimate cuts in the sector, and the estimate increases in the Energy sector, I suspect the Energy sector might just keep its crown in 2009 as well, but that is a long shot prediction. Most analysts are using very conservative pricing assumptions in their forecasts for the Energy sector (relative to that implied in the futures market), so earnings estimates still have lots of room to rise. Keep in mind that these numbers are snapshots, when you should be thinking about a movie. At the end of February, the Financials were expected to gather 22.1% of all earnings for 2008, and Energy was expected to only get 16.0%. For 2009, the expected earnings shares were 15.0% for Energy and 22.4% for Financials.

For many years Financials were clearly the dominate factor in the overall market, despite generally selling for below market P/E’s. Based on 2008 earnings, the Financials have a P/E of 14.2x and based on 2009, only 9.4x. However given the pace of estimate cuts in the sector, the true P/E is probably higher since the actual earnings will be significantly lower. Energy has just taken the throne as the cheapest based on 2008 earnings trading at 11.2x, and 10.3x based on 2009 expectations. The Tech sector is far and away the most expensive in the market, trading for 18.8x 2008 and 16.0x 2009 expectations.

Keep your eyes on the revisions. Unless the spreading of economic weakness to the rest of the world causes oil prices to plunge (and the recent trends are very much in the other direction), you can have much more confidence in Energy earnings forecasts actually being achieved (or exceeded) than is true with the Financials.

The S&P 500 as a whole is trading for 14.8x and 12.4x, 2008 and 2009 earnings, respectively. Based on a blend of 60% 2008 earnings and 40% 2009 earnings; that translates to a 7.21% earnings yield, which looks extremely cheap relative to a 4.25% ten year T-note. Even against the AA corporate bond yield of 6.37% it looks attractive. However, the current level of expectations for corporate earnings still implies that profits will stay well above their historical averages as a share of GDP. That would be an exceedingly rare occurrence during a recession. The comparison between the earnings yield on the S&P and the 10 year T-note is in my opinion more a reflection of the extreme unattractiveness of long term T-notes at this point than stocks looking particularly cheap in general, however there are attractive stocks out there. It appears that the flight to quality has caused a massive bubble in the price of T-notes. This is far and away, in my opinion, the most significant bubble in the market today, not the price of oil. The prices are hard to justify given the risk that the massive injections of liquidity by the Fed to ameliorate the credit crunch will end up fueling the fires of inflation.

Neil Malkin contributed significantly to this report.

Data in this report, unless stated otherwise, is through the close on Thursday 6/12/2008

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