Estimates Fall As We Head Into Reporting Season

This week Alcoa (AA) will report and the second-quarter earnings season will be underway in earnest. At this point the reported data is not that significant.

To date, just 28 firms within the S&P 500 have reported second-quarter earnings. Though limited in number, the results have been somewhat encouraging. Positive surprises are leading disappointments by a 3.2:1 ratio, inline with recent historical norms. The median surprise is also inline with recent history, and perhaps a bit better than normal at 4.33%. Expect both the surprise ratio and the median surprise to jump around quite a bit in the early going of the earnings season.

The median year over year EPS growth rate of 10.26% would be wonderful news for the market, if it can be held on to as the season progresses. Given the expectations for those that have yet to report that seems possible. The median expected EPS growth rate for the 94.4% of firms that are yet to report is 9.64%. Given the propensity for positive surprises to outnumber disappointments, on a median EPS basis, the second quarter earnings season could be far better than the mood of the market would seem to indicate.

Energy is currently expected to win the growth derby, not exactly a shocking idea with oil currently hovering in the $140 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. The 30.0% year-over-year growth in EPS for the sector looks very conservative to me (but up from 22.3% last week, and 19.7% two weeks ago).

Tech and Industrials are currently expected to win Silver and Bronze in the second quarter, with growth of 21.5% and 17.7%, 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 7.8%. Consumer Durables follows closely behind with an expected drop of 1.3%. 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 3.9% 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 repurchase, which even though it has slowed in recent months, will still reflect what happened last year. Oddly, increased share counts will also help boost EPS among the Financials. Since the ones that have increased their share counts the most (by going hat in had to the sovereign wealth funds looking for new capital) are the ones that are likely to reports losses, the loss per share will be less. In addition to the extent that firms have large operations overseas, they should benefit from the currency translation effects of the weak dollar. 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 year’s fourth quarter. The blame for net income decline once again goes to the Financials (with best supporting actor nomination for the Consumer Discretionary), 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 12.9% below the second quarter of 2007.

In the Financial sector, total net income is expected to be 56.9% lower (was 41.9% last week). In both cases, this marks an improvement over the first quarter when the overall S&P 500 was down by 15.3% and the Financials were down 79.3%. Things are also falling apart for the Discretionary firms, even despite the massive forced lending program known as the stimulus checks. Total net income for the sector is expected to be down 30.4% from a year ago, and even worse showing than the 9.2% year-over-year decline posted in the first quarter.

Looking at the very early reports in so far, things look very bleak indeed for the Financials with the total net income of the four firms that have actually reported so far down 89% from a year ago. Those four firms reported a total of $705 million in profits this year versus $6.4 billion last year. There will be more massive write-offs this quarter, but hopefully not quite as massive as we have seen in the previous two quarters. The key flavor of the quarter this time around should be write-offs related to counterparty risk with the monocline insurance firms like Ambac (ABK) and MBIA (MBI), which have finally lost their AAA designations. Total net income for all the S&P 500 firms that have reported so far is 41.8% below last year.

Energy is expected to be the strongest sector, with total net income climbing 19.1%. The analysts have been raising their sights for the sector rather dramatically. Just last week growth of only 15.8% was expected, and 14.4% growth two weeks ago. However, that is significantly slower growth than the 25.8% posted in the first quarter. With oil at $135 or so, and natural gas over $13, the 19.1% rise in total net income for the sector is seems very conservative, and points to the amount of escalation on the cost side of the equation for the energy firms. Yes, the price of oil is going up, but so too is the price of the steel pipe they put in the ground when they drill a well. While overall, there is a significant tendency for analysts to be too conservative in their earnings estimates, I suspect that energy will be the place with the most potential for large positive surprises.

Tech looks like a strong runner up in an otherwise weak field, with growth of 12.6% expected. Beyond that, growth does not look very inspiring, Staples looks like it will capture the bronze with growth of only 6.2%. Five sectors are expected to post lower total net income in this year’s second quarter than they did a year ago.

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 fell back again, after a slight blip up last week. It has now fallen in five of the last six weeks. It is now at 0.80, a reading that we generally consider slightly negative, down from 0.84 last week, and 0.91 two weeks ago. The overall pace of estimate revisions is past the peak for this quarter, and is starting its seasonal rise. Over the last four weeks there have been 1,365 changes in estimates: 606 up and 759 down, up % from 1,289: 590 up and 699 down last week. Over the next five or six weeks the total number of revisions will most likely triple from current levels. The ratio of firms with rising mean estimates to falling mean estimates is 0.92, slightly stronger than the revisions ratio, and in neutral territory. Two sectors are in positive territory, two in neutral and six in negative territory.

Energy was far and away the strongest with over six increases for every cut. While estimate increases were widespread in the sector, firms worth highlighting would include Noble Energy (NBL), Occidental Petroleum (OXY) and Southwestern Energy (SWN) From a total economic impact point of view, significant increases were also seen for all of the big three, Exxon (XOM), Chevron (CVX) and Conoco (COP).

Tech followed with almost increases for each cut. Dell Computer (DELL) was the most significant contributor to the Tech strength, although chip stocks were generally strong as well. Staples and Utilities were just neutral to slightly positive, and all other sectors were decidedly negative. Telecom fared the worst this week, but that was on a very small number of total revisions. The Financials were once again very weak, with over three cuts per increase, although the pace of estimate cuts is less than we have generally seen in recent months. Keycorp (KEY) and Zion (ZION) were among the weakest of the Financials. Lehman Brothers (LEH) and Morgan Stanley (MS) were also beaten down by the analysts.

The 2009 revisions story is similar to the 2008 story, just slightly weaker. The revisions ratio also resumed its decline, and is now solidly in negative territory. It fell to, 0.76, from 0.82 last week, and 0.89 two weeks ago. We still consider that to be in neutral territory.

Virtually all the strength is in the Energy sector, with a revisions ratio of 5.00. Tech also put in a decent showing at 2.38, or five increases for every two cuts. The Energy sector accounted for over one quarter off all estimate increases over the last four weeks, and less than five percent of the estimate cuts. Twelve of the 37 firms in the Energy sector have seen their 2009 earnings estimate increase by double digits over the last four weeks alone, including all of the big three (XOM, CVX and COP). In Tech, the PC manufacturers, DELL and Apple (AAPL) 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 Keycorp (KEY), Fifth Third (FITB), Huntington (HBAN) and U.S. Bankcorp (USB).

The total number of revisions for the whole S&P 500 for 2009 is also well past its seasonal low point, and starting up out of the valley. There were a total of 1,234 revisions: 534 up and 700 down. This is up % from 1,162 (524 up and 638 down) last week. As second quarter earnings start rolling in, expect the pace of revisions activity to pick up significantly. The ratio of firms with rising mean estimates to falling mean estimates is 0.88, 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 decisively dethroned on both counts. On the Market cap front it just slipped to third place behind Energy. While still in second place based on 2008 earnings, it seems likely that they will lose that slot as well. Still, despite their current problems, the Financials are still a very significant influence on the market. 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 22.0% of the total net income for the S&P 500. In 2008, that is currently expected to decline to 14.5% before rebounding to 19.1% 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 20.2% from 15.6% in 2007. However, analysts expect a Financials restoration next year, with the sectors share rebounding to 19.1% while Energy slips back to 18.5%. Given the trends in the earnings estimates, it strikes me as highly unlikely that the Financials will regain their throne.

I expect that the expectations for total earnings for the Energy sector will surpass those of the Financial sector for 2009 within two months (probably sooner).

On the market cap (and index weight) front, Tech overtook the Financials a two months ago and currently stands at 16.9%. Energy has moved into second place when it comes to index weight at 15.6%. The Financials have plunged to 14.1% of the index. As recently as the end of February, Financials had a 17.2% index weighting versus 15.7% for Tech and just 13.0% for Energy. 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 first time we had a complete read on 2009), 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. In general it seems as if the Energy sector is consistently gaining 0.2% of share for each year every week, with a similar decline for the Financials. If those trends continue, then Energy could be as dominate on the earnings front in 2008 as the Financials were in 2007, and the Financials could slip into third place in total earnings behind Tech.

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 13.6x and based on 2009, only 8.5x. 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 10.8x, and 9.7x based on 2009 expectations.

The Tech sector is far and away the most expensive in the market, trading for 17.1x 2008 and 14.5x 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 14.0x and 11.6x, 2008 and 2009 earnings, respectively. Based on a blend of 60% 2008 earnings and 40% 2009 earnings; that translates to a 7.51% earnings yield, which looks extremely cheap relative to a 3.97% ten year T-note. Even against the AA corporate bond yield of 6.48% 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 Wednesday 7/2/2008

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