EARNINGS ESTIMATES ARE A MAJOR MARKET HURDLE
As the Q4 2009 earnings season comes to a close it’s important to take a look at the overall earnings picture. With over 98% of the S&P 500 reporting it looks like Q4 earnings will come in a little shy of $16.80. As we fully expected the analyst’s estimates once again proved to be well below the mark as 72% of all companies outperformed expectations. This has resulted in substantial estimate increases and has been one of the primary reasons why we have maintained that investors could not short this market for the entirety of the last year. The earnings upgrade cycle has served as wind at the market’s back, but the optimism is now becoming an impediment.
In the last year analysts have substantially contributed to the equity rally as they upgraded stocks and increased their estimates. The “Monday upgrade” rally has become a hallmark of the move higher in stocks as analysts spend their weekends adjusting estimates and preparing for Monday morning upgrades and downgrades (though mostly upgrades). In just the last 8 weeks analyst’s Q1 2010 estimates have jumped 4%. In addition, they are growing increasingly optimistic about the latter portion of the year (where I believe things get potentially messy). The H2 estimates have continued to creep higher as Q4 earnings were released. Analysts are now calling for $78 in operating earnings for FY 2010. The 2011 estimates have also surged. Analysts now expect $94 in operating earnings for 2011. That would represent back to back years of 20% earnings growth - something that has never happened before in the history of the United States equity market.
The real problems lie in the latter portion of 2010. Analysts are currently calling for 38% year over year growth for Q2, 30% year over year growth in Q3, and 27% growth in Q4 2010. Granted, these are coming off of easy comps, however, we have yet to see any real revenue growth. Including the very easy comps with financials, sales grew just 5% year over year in Q4. If we exclude the financials revenue growth was nearly non-existent at just 1.1% year over year. This is best visualized in the image below which shows the S&P 500 by revenue per share. The trough is clear, but there is certainly no v-shaped recovery here. At best, we are bumping along the bottom.
We are well into the economic recovery (ISM at 5 year highs and record highs in the ECRI’s leading indicators) and the ultimate L-shaped recovery remains in corporate revenues. The vast majority of the rebound in earnings is non-organic and unsustainable. Margins have expanded to pre-crisis highs as companies squeeze every last drop down to the bottom line. Analysts expect earnings to return to near 2007 levels without any real revenue growth. I find that hard to believe. If you’re still confused as to why insider buying is non-existent in this market look no further than the revenue line of corporate income statements.
As sentiment has becomes very optimistic in recent weeks the Expectation Ratio has taken a bit of a spill. The ratio peaked in the back half of 2009 along with the market and is now forecasting a far more difficult future for corporate earnings. Without a substantial acceleration in revenues it is unlikely that this market is headed anywhere fast. While it looks as though we likely have one more quarter of very easy earnings comps (Q1 2010) the real test will come in the latter portion of the year where estimates are extremely optimistic. With little to no signs of organic growth I find it hard to believe that the bull market in earnings can continue. That will serve as a major hurdle for the equity markets in 2010.*
* The ER is a longer-term indicator that not only forecasted the 2007 & 2008 downturn, but also forecasted the 2009 bottom in stocks well in advance. It’s a cyclical indicator and should be viewed with a bit of a longer time horizon.
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Another metric to gauge the recovery.
Corporation Income Tax Forecasts for FY 2010
“For most states, corporate income tax collections represent a much smaller share of state tax revenues than other sources, on average representing almost 7 percent of the total. But in an environment where revenues are scarce, every source is important to the bottom line. More than half of the responding states expected these collections to decline.
* Twenty-three states anticipated that corporate income tax collection would drop below last year’s levels, with 13 of these forecasting double-digit declines. The biggest drops were forecasted by Ohio (-80.8 percent), Delaware (-65 percent), Illinois (-33.8 percent) and Minnesota (-31.7 percent). Two other states expected declines greater than 20 percent: Louisiana (-29.5 percent) and Montana (-26.5 percent).
* Thirteen states and Puerto Rico estimated that corporate income tax collections would rise compared to last year. The biggest expected increases were reported by Wisconsin (16.6 percent), Oregon (13.4 percent), Puerto Rico (13 percent) and Idaho (12.8 percent). Wisconsin and Oregon were among the states that increased corporate taxes.”
http://www.ncsl.org/?tabid=18858#CIT
What is the equation/ the variables for the ER ?
Thanks
However, there’s been a consistent trend of analysts lowering their estimates as the quarters approach, allowing companies to “beat” the revised lower estimates…
That said, I agree with you TPC — we’re clearly in/approaching far more of a show-me phase, when companies and analysts won’t (I hope!) be able to say there’s a hockey stick in E coming next year…
PS. Does your expectation ratio graph go back further in history? I’d be curious as to what it looked like 07-08.
Commercial and Industrial loans are still sloping down (as of 25-Feb-10) – that doesn’t seem to correlate with a recovery. Therefore, profits are a short term bounce or at best a new operating base brought on by opex cuts and games with accts recv and payables.
If we were recovering, I would expect some growth in commercial/industrial loans and insider buying as they see things improving. If there is no real growth but a new lower operating baseline – what happens with stock prices?
http://research.stlouisfed.org/publications/usfd/20100226/USFD_book.pdf
Earnings growth YoY for 2010 for S&P500 per your chart is projected to grow from 70% in q1 to 26% in q4. that does not seem to me to be unachievable, even with a slow growth in revenues (which you might assume will increase its rate of growth as, or if, the recovery lengthens). remember, the stimulus that was passed last year is going to be spent over a longer time than envisioned, likely into 2011, as such projects such as weatherproofing never got off the ground this winter (there is a story of bureaucratic inefficiency).
so i know this is your thesis for this year, but i think you are too negative here.
just saw this re 2/10 ISM: http://www.bloomberg.com/apps/news?pid=20601087&sid=aWbgPNraMelE&pos=1
Why are you so bullish Chris? Any actual fundamental reasons? Sounds to me like you’ve jumped on the bull bandwagon about 70% too late.
I’d love to hear your bull thesis as well. My thinking coming into 2010 was that H1 would be relatively robust, but the market has gone almost nowhere.
Now we’re staring at global tightening, an end to the stimulus, record high ECRI readings, record high ISM data and back half earnings estimates that are lofty.
The time to get really aggressive was 12 months ago. Not today.
i started buying financials aggressively early in 2009 when you’all were talking about nationalization (in america? medicine maybe, banking never), so actually i was 10% too early.
i have 30 years of investing experience, and everything that i have experienced tells me that the financial crisis represents the best buying opportunity in my lifetime. i was totally out of the market before 1/2009; in fact, i moved all of my money from money market funds to treasury bills when the buck broke (although not in my fund). had been out for two years when i saw corp fin deals being structured and priced in a way that made totally no sense, so that was my tell. was too scared to short however.
low short term rates and a steep yield curve is a sweet spot for financials; doesn’t take more thought than that. as long as that persists, i am staying overweight financials.
too many of you are so annoyed with “misguided” monetary policy that you don’t realize how sanguine these conditions are for equities, especially financials, but only for so long as it lasts…when the fed raises the FF rate to 1%, i will be out.
if you looked at past recoveries and past sovereign debt crises, you will see that equity returns have been stellar. a slow recovery is just fine by me. if there is a double dip, i will be wrong, but i am taking that risk.
i love it that there is a wall of worry; lengthens the recovery for equities. when things get rosy for you guys, that will be the time to sell.
Some of us are on record actually calling the market bottom:
http://pragcap.com/coming-this-week-the-m2m-rally
Your first comments here are in 2010 so it’s impossible to verify your claims. I have been pretty consistent throughout the move higher. I said it was government induced and would be driven by earnings expectations. Of course, I would never claim to have captured the entirety of the move, but I always hedge so it is what it is.
I think your bullishness is a little late to the party. As I said above, the time to be really aggressive was last year. This is truly a stock picking and hedgers market now.
you flatter yourself if you think i could not have made successful trades before i started reading your blog.
i suppose i could copy and paste some trades i did in january 2009, but that is not the point of this exercise.
the whole point is making money, not being right about what the right monetary policy is (although you have to understand monetary policy to invest)
right now, with the ISM service number coming in higher (90% of economy), after the ISM manufacturing number came in higher previously, i see continued recovery which, in the current 0-.25% FF interest rate environment, screams long equity, especially financials, but again only for so long as it lasts
while the current favorable conditions may not last long enough, i see the indexes filling the lehman gap…when i don’t know, but if these conditions persist, that is what i see…i will be happy to sell then, unless i have sold before because the fed no longer wants to be my friend.
I’m not trying to flatter anyone. I just don’t see the purpose in come here and saying: “I am right because I have been right all along, but I can’t prove it to any of you”. That’s all. We are all wrong a lot. That’s part of investing. If you have been right then congratulations. You will be a worthwhile contributor to the site and I will enjoy listening to your future predictions.
My point is, if you’re going to make claims it makes no sense to just say “1+1=2″ because I say so. Tell us why.
Everything I write here is backed up with proof or justified in some manner. This doesn’t mean it’s always correct, but there is a method to my madness.
Too often, investors simply walk around say, this trend line was broken therefore the index is going up. Really? That’s not helpful. Connect the dots for us. Provide some evidence of claims. How about some historical proof?
You say history proves credit busts are followed by strong recoveries. What history? The US has only been involved in one credit bust and I would discount it entirely because the USA was an entirely different machine back then. Japan? Different animal as well and not really positive results there either.
As for the ISM – it is a coincident indicator. Nothing more. I have studied ISM data for countless hours and there is NOTHING predictive in it. Just study the 2000 downturn when ISM was 50+ well into the equity downturn or the 2002 debacle when ISM was 50+ throughout most of that year when equities got crushed.
Fed easing? The BOJ has been at 0% for 20 years….
And please bear in mind I am trying to be constructive. If I come off as condescending or rude then please know that is not my intention.
If you wait for FF to go to 1% you will be looking for a seat when the music has already stopped. How stellar did equity returns turn out for those who bought the initial bear market rally of the 1929 crash?
It’s good to have alternate views – test your assumptions
Chris, I think what you are investing in is extend and pretend rather than the spread. To be long financials, I would keep an eye on accounting standards more than the interest rate.
dh, thanks for the thought, i am concerned about this.
i think the CRE resolution will involve alot of extend and pretend. as for bank regulatory capital shenanigans, you may be interested in reading http://www.zerohedge.com/article/wells-operating-below-fdic-statutory-minimum-30-tier-1-capital-total-assets-ratio-courtesy-f which speaks to your point.
there are landmines out there; i just think the fed is giving banks the leeway to earn their way out of their mess so that on balance i think it is a good bet.
Chris, thanks for the link, interesting article. It didn’t address what is probably the most important issue from an investment point of view though and that is, will the outsize profits from the current spread come in at a faster rate than the losses have to be recognized. If so, no problems, if not then another round of capital raising might be in order.
I have to agree with you that the Fed and congress have made it very clear that the big banks will not be allowed to fail.
you are not being constructive when you purport to quote me (I just don’t see the purpose in come here and saying: “I am right because I have been right all along, but I can’t prove it to any of you”), in quotes mind you, when i have said nothing like that.
i was only responding to the claim that i was 70% late to the party, which i was not…but i should have just let it go, since that is all history.
i could cast aspersions at you too for relying on a expectation ratio that is so proprietary you cannot explain it adequately for anyone to be able to consider it independently…but i won’t.
i actually told you guys, who decry current money policy so passionately, that i think you have your eye on the wrong thing: i will repeat, this environment of extremely low short term rates, which we have been told will last for an extended period of time (because inflation is largely absent), coupled with a steep and growing steeper yield curve, spells money to me, especially for financials. you can either agree or disagree with me, which is fine; i am looking for counterfactuals to my analysis as well. perhaps you think it is too simple. if so, you should know that simple is not bad in investing analysis, imho.
the distinction you placed on this recession, that it is a credit as opposed to inventory recession, is largely a distinction without a difference for an equity investor (as opposed to an economist). now, if you are a mortgage banker or a securitization lawyer, then i am sorry for you. but this recovery will generate enviable equity returns over a period which, granted, will last longer than a normal recession. as for the japan comparison, too many demographic, socio-economic and cultural differences for me to see it as highly correlative…although if we keep on increasing our debt/gdp, then maybe i have to concur.
bruce berkowitz has gone on the offensiive; buffett says the housing recovery will take shape by 2011 (methinks he is really just talking his book on that one); paulson, einhorn and others are overweight financials; this is a good neighborhood for me to be in.
Look, my only point is that I wrote a very detailed analysis of the current earnings environment and your response was:
“that does not seem to me to be unachievable” and “I think you are too negative here”
You provided no actual evidence that backs any of your claims. There have been hundreds of commentators like you on this site who come here and make predictions that are backed up by zero evidence and none of them are still around. I challenge them to back up their claims because it is counterproductive to come here and say “you are too bearish or bullish because I think so”.
I write the site largely because the readership is extremely intelligent and challenges my own thinking. I am all for thoughtful debate. That’s all.
gee i guess i am not intelligent like your other readers…
you are way more concerned about earnings expectations than i am…i guess because of your expectations ratio. i am way more interested in the yield spread than you are…see http://scottgrannis.blogspot.com/2010/02/fed-is-behind-tightening-curve.html the fed prints money, the banks make money. some people complain that in this environment you would have to be an idiot not to make money running a bank. i agree, but i don’t see anything to complain about; i see an opportunity to invest.
now do i think that we all will eventually pay for the fed keeping FF rate so low for so long? sure. that is why you have to take advantage of this current gift that we will all be paying for later while you can.
gross calls it shaking hands with the government, although i wouldn’t be keen on buying aig and fnm debt like he is, too messy for me. overweight financials is how i shake hands with the government.
how do you shake hands with the government? oh, i forgot, because you disagree with its monetary policy, you decline to participate…is that it?
so give me a reasoned analysis why a diversified portfolio of financial stocks won’t make you money this year?
Chris, I never said you weren’t a good contributor. I would just like to see market predictions backed up by reason. Trust me, I am very open-minded. I encourage readers to challenge my position.
Chris said, “the distinction you placed on this recession, that it is a credit as opposed to inventory recession, is largely a distinction without a difference for an equity investor”
Wow, you’re so far out in the weeds I need a tow truck to pull you out of this one. For a start you might want to look at a chart of the DOW in the 1930′s and the Nikkei from 1990 to today:
http://finance.yahoo.com/echarts?s=^DJI#symbol=^DJI;range=my
http://finance.yahoo.com/echarts?s=^N225#chart1:symbol=^n225;range=my;indicator=volume;charttype=line;crosshair=on;ohlcvalues=0;logscale=on;source=undefined
You’ll notice there is a huge difference between Credit recessions and inventory recessions for equity investors.
While its true Japan has demographic, socio-economic and cultural differences these are unimportant differences in the grand scheme of things. The important similarities are striking; a massive credit bubble and a failure to liquidate bad debt.
perc, we are replacing private debt with public debt, and if this puts us onto the path of japan rather than on a growth path (i think the jury is still out on that one), then i will concede your point in a few years…until then, still looking to make money (and i find shorting really scary).
btw, i like old land rovers…plenty of towing capacity in low gear.
General observation…
Shorting is scary, well discomforting more than scary — everything about it (in terms of its impact on the P&L, to the impact on your portfolio’s exposures) works against behavioural norms/comfort zones.
Sorry to insist, TPC. Would you mind telling us more about the ratio: equation and variables?
Thanks
Here you go:
http://pragcap.com/resources/exptectation-ratio
Even ignoring TPC’s proprietary ER, I think the fact it works means that analyst forecasts are severe lagging indicators (those darn analysts just don’t seem to get smarter … oh, I forgot there not there to help **US** make money). Thus, if we are in a bullish cycle, analysts will likely be too optimistic. But then again, earnings haven’t driven stocks in the short-medium term (ie value investing) since never.
The SPX EPS estimate is silly with the current mark to fantancy accounting rules. The market took of when Congress forced the FASB to abandon the mark to market rules. Revenue per share tells the story.