Despite Positive Surprises, Stock Analysts Continue To Cut

We are about at the halfway point in the second-quarter earnings season. The results so far have been very mixed: encouraging in median EPS growth terms, but downright awful in terms of total net income growth. Given the mix of which firms have reported so far and those yet to come, we should see some improvement on both fronts from here on out.

So far, 245 firms, or 49% of the S&P 500, have reported. It is not a representative sample since some sectors historically report sooner than others. This however, is good news, since a much higher percentage of the firms in the “bad sectors” like Financials and Consumer Discretionary, have reported than in the “good sectors” like Energy.

Nonetheless, this very limited sample is somewhat encouraging. Positive surprises are leading disappointments by a 2.8:1 ratio, inline with recent historical norms. The median surprise is also inline with recent history, and perhaps a bit better than normal at 3.61%. Expect both the surprise ratio and the median surprise to jump around quite as more reports are released.

The median year-over-year EPS growth rate of 11.43% is wonderful news for the market. And it looks like it will probably hold up. The median expected EPS growth rate for the firms that are yet to report is 8.11%. 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.

Based on the early actual returns, Tech is winning the growth derby, with median EPS growth of 25.0%. This is based on the results of 38 companies, or 53.5% of the total Tech firms in the index.

However, perhaps the most impressive showing has been that of Health Care, which is currently holding the silver medal spot with median EPS growth of 18.7%, just barely edging out Energy so far, which is at 18.5%. However Health Care is showing 9 positive surprises for each disappointment, with a median surprise of 4.82%. This is not based on just a handful or results either, as almost two-thirds of Health Care reports are already in.

Energy on the other hand has just over one-third of its results in, in terms of number of firms reporting, and far less than that based on probable total earnings. Its surprise metrics are roughly in line with the overall market with a surprise ratio of 3.7:1 and a median surprise of 2.99%.

The Financials have been the weakest sector by far, with the median EPS dropping by 28.1% from a year ago. The sector is responsible for over 40% of all the earnings disappointments to this point, and disappointments have matched positive surprises in number.

At this point though it is the expectations for those that have yet to report that are just as important as those that have actually reported. The remaining Energy firms are expected to post median EPS growth of 42.6%. That should lift the sector into the top spot for earnings growth.

Tech will most likely take the silver medal spot, and the race for bronze currently looks like a toss up between Health Care and Industrials. The remaining Industrials are expected to post growth of 17.4% while the remaining Health Care firms are expected to post growth of just 8.1%, but Health Care currently has a big lead. Both have been surprising to the upside and are about two thirds through the race.

The expected results for the remaining Financials are not as bad as the ones which have already reported, but are still fairly ugly at -3.3%. Materials should provide the worst remaining results at down 8.9% expected and the remaining Consumer Discretionary firms are expected to show a 2.2% decline which just might push the sector into negative territory for the season.

Some of the factors which should help median EPS growth are share repurchases, which though have 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 hand to the sovereign wealth funds looking for new capital) are also the ones that are likely to reports losses, so 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.

Keep in mind that median growth rates are inherently equally weighted, so the growth rate for Cabot Oil and Gas (COG) is just as significant to the results for the Energy sector as the growth rate for Exxon (XOM).

While on a median EPS growth basis, things might look okay, the same is not true on a total net income basis. This is shaping up to be yet another very ugly quarter.

The blame for net income decline once again goes to the Financials (with best supporting actor nomination for the Consumer Discretionary). Overall, the second quarter is now expected to be even weaker than the first quarter and the fourth quarter.

Overall, total net income for the S&P 500 is expected to be 22.1% below the second quarter of 2007. This number is deteriorating rapidly, last week the decline was only expected to be 17.3% and 14.7% two weeks ago. In the Financial sector, total net income is expected to be 92.7% lower (was 73.8% last week and 62.9% two weeks ago).

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 36.3% from a year ago, and even worse showing than the 18.8% year-over-year decline posted in the first quarter.

Looking at the reports in so far, things look very bleak indeed for the Financials with the total net income of the firms that have actually reported so far down 86.9% from a year ago. The 50 firms reported a total of $5.5 billion in profits this year versus $42.4 billion last year. Things are not expected to get any better as the remaining reports roll in. The firms yet to report are expected to show actual red ink in aggregate, not just lower profits.

Total net income for all the S&P 500 firms that have reported so far is 22.5% below last year, that should stay fairly stable as the total net income for those yet to report is expected to be down 21.6%. This is in large part due to the fact that the bulk of the energy earnings have yet to come in. Total net income for remaining firms is expected to fall for eight of the ten sectors.

Energy is to be the strongest sector, so far with total net income of the 14 firms that have reported up 26.9%. While the remaining firms are not expected to be quite that strong, up 18.4%, they should still keep the sector comfortably in first place. Next quarter, the analysts are expecting Energy to really hit a gusher with 62.8% growth expected.

Tech looks like a strong runner up in an otherwise weak field, with growth of 22.0% so far. However, the remaining Tech firms are not expected to be anywhere near as strong, actually declining slightly. Still the strong results so far should ensure that Tech holds on to the silver in total net income growth. Health Care will most likely take the Bronze with 7.0% growth.

Unlike 2008, there is no mechanical reason for analysts to raise their numbers for 2009 in response to an earnings surprise. While the revisions ratio did rise, it remains deep in negative territory. The ratio rose to 0.66, from 0.56 last week, and 0.61 two weeks ago. In other words, despite all the positive earnings surprises, over the last four weeks analysts have cut three estimates for every two they have raised.

Virtually all the strength is in the Energy sector, with a revisions ratio of 3.51. Utilities and Health Care also put in decent showings at 1.81 and 1.61, respectively. The Energy sector accounted for over one quarter off all estimate increases over the last four weeks. Energy firms showing noteworthy strength include oil service majors Baker Hughes, Halliburton (HAL) and Schlumberger (SLB).

The revisions picture for the Financial sector is even worse for 2009 than it is for 2008, coming in at 0.12, or over eight cuts for every increase. Revisions like these will eat away at the robust earnings rebound seen for 2009 (unless 2008 gets cut faster). If the Financials were excluded, the revisions index would pop to 0.94. We do not seem to be getting out of the woods on the Financial sector front.

While there is weakness throughout the sector, major regional banks seem to be the worst hit. In particular, weakness at BB&T (BBT), Comerica (CMA), SunTrust (STI) and Zion (ZION) was noteworthy.

The total number of revisions for the whole S&P 500 for 2009 is also well past its seasonal low point. There were a total of 2,067 revisions: 819 up and 1,248 down. This is up 36.4% from 1,515 last week (543 up and 972 down). The ratio of firms with rising mean estimates to falling mean estimates is 0.66, in line with the revisions ratio.

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.

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 recaptured second place from Energy. However, it has now slipped into fourth place behind Tech and Health Care based on 2008 earnings. Still, despite their current problems, the Financials are still a very significant influence on the market.

Even with all the disasters in the sector, for 2007, the Financials accounted for 22.8% of the total net income for the S&P 500. In 2008, that is currently expected to decline to 12.1% before rebounding to 17.7% 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 21.1% from 15.6% in 2007. Energy should keep the earnings crown for 2009 as well, gathering 19.9% of all the earnings of the S&P 500.

On the market cap (and index weight) front, Tech overtook the Financials a two months ago and currently stands at 17.0%. The Financials have plunged to 14.6% 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. A year ago before the credit crunch hit, Financials were expected to gather 26.3% of 2008 earnings and held a 19.4% weighting in the index. Energy represented just 10.9% of the total market capitalization and was expected to get 12.9% of the total earnings in 2008. 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 and 2009 as the Financials were in 2007.

For many years Financials were clearly the dominate factor in the overall market, despite generally selling for below market P/Es. Due to an implosion in earnings that has been far worse than the dismal market performance of the sector, the Financials now have the highest P/Es based on 2008 earnings, displacing the perennial high P/E sector Technology. Based on 2008 earnings, the Financials have a P/E of 17.1x. However, given the expectation that the bleeding will stop next year, the P/E based on 2009 earnings is just 9.6x. 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. That is the first time I can recall that happening.

Energy has just taken the throne as the cheapest based on 2008 earnings trading at 8.9x, and 7.9x based on 2009 expectations. There is no question in my mind that Energy is the cheapest sector of the market, and every portfolio should be overweight in it. The Tech sector is still a bit on the expensive side, trading for 17.0x 2008 and 14.5x 2009 expectations. Health Care looks interesting trading at 14.1x 2008 and 12.7x 2009 earnings.

Keep your eyes on the revisions, they give you the best clue as to if the earnings will be achieved and if the P/E’s are for real. While the recent declines in oil prices may cause the upwards revisions to moderate for the Energy sector, most analysts are using very conservative price assumptions.

The S&P 500 as a whole is trading for 14.1x and 11.7x, 2008 and 2009 earnings, respectively. Based on a blend of 50% 2008 earnings and 50% 2009 earnings; that translates to a 7.75% earnings yield, which looks extremely cheap relative to a 4.10% 10-year T-note. Even against the A rated corporate bond yield of 6.33% 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 7/24/2008

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