WHAT TO EXPECT THIS EARNINGS SEASON
Another earnings season is around the bend and it’s shaping up to be another good one.  As we’ve repeatedly mentioned over the last 6 quarters the environment is and remains particularly ripe for profit outperformance. The trends that have been in place for the last 6 quarters remains largely intact. Analysts remain woefully behind in terms of raising their estimates (see here) and corporate profits remain a margin story.
Figure 1 shows the corporate profit margin over the last 40 years.  Most important in the last few years is the turnaround in margins since Q4 2008 when enormous cost cutting campaigns kicked in.  The one remarkably positive sign during this recession has been the ability of corporations to remain lean and mean. They have done a superb job in cutting costs and maintaining a fairly robust bottom line. As you can see, profit margins are surging in recent quarters and should continue to trend higher as unit labor costs remain low (see figure 2) and revenues begin a slow rebound (the extent of this revenue rebound will be the key driver of any future market performance). This trend has continued this quarter and should help power another quarter of “better than expected earnings”.
Figure 1
Figure 2
While revenues have certainly bottomed it remains the key missing ingredient in the recovery. In order for stocks to continue their record breaking trajectory we must begin to see revenue growth. According to recent jobs data it looks like the labor market is beginning to firm. This is a clear sign that companies are beginning to see more stability in their top-line growth. This also means companies are beginning to incur extra costs and the margin story will cease to be the primary driver of earnings without equal or greater revenue expansion. One bright sign here is that revenues significantly lagged the equity market rebound during the 2003 recovery. As you can see in Figure 3 revenues didn’t substantially recover until 2004. We’re seeing the same thing occur with this recovery although the extent of the rebound in revenues remains questionable as consumer balance sheets remain underwater and the global economy continues to drag itself out of recession.
Figure 3
Perhaps most important in all of this, however, is expectations. As we mentioned earlier, analysts have been woefully behind the earnings recovery. This is best reflected in our expectations ratio which had been trending higher since just before the market bottomed last year and only recently began to roll over. This shows that analysts estimates are becoming increasingly in-line with actual earnings and could create an environment that is not quite so friendly to the usual “beat and raise” environment we have all become accustomed to. If a strong revenue rebound fails to materialize in the back half of the year analysts estimates will prove too high and stocks will respond negatively.
Figure 4
Based on my analysis, I believe we are in for one more quarter (Q1 2010) of easy analyst comparisons and then the heavier lifting begins as estimates ratchet up in Q2 2010 and even higher in the back half of the year where analysts estimates are very optimistic. If we don’t see a stronger rebound in revenues in the next two quarters companies will not match these optimistic outlooks.
Currently, the market appears to be front-running the current earnings season and is pricing in another very strong earnings season. Don’t be shocked to see another quarter of very high percentage earnings beats and tepid revenue performance. Whether that is enough for an already optimistic market remains to be seen. My guess is we will see another “sell the news” earnings season. Companies are running out of tricks to pull from the cost cutting bag and revenues haven’t quite stabilized to the extent that would make most executives highly confident in their full year earnings. If we don’t start seeing a pick-up in top-line growth this market is not going to be celebrating for long and the recent optimism in stocks will be proven wrong.
Cullen Roche
Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.
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32 Comments
thanks for the update TPC!
would be great if you could provide another update before q1 earnings season starts.
is it possible to break the expectations ratio down into different sectors?
this could have been pretty helpful.
take the latest rallye in the retail sector, which was fueld by blowout earnings.
judging the analysts commentary and the latest earnings reports (JBL,RHT) expectations appear to be pretty high in the tech sector, which could it make vulnerable in april.
again, thanks for your work!
Interesting to see profit margins range between 6%-10% for about 25 years before rising over trend during the tech bubble and then the housing bubble. We are already back up to 10% so why do you think margins will expand further? Unless we create another bubble, it seems like profit margins are close to topping for this cycle already.
Thoughtful analysis as always but I do believe that you are absolutely glossing over the employment situation,
” According to recent jobs data it looks like the labor market is beginning to firm.”
The ridiculous U3 remains flat for a month and we sigal everything is looking up?
While the more relevant U6 (at 16.8%) is ticking up steadily and no one says squat.
And the more up to date Gallup survey just topped 20% underemployment. And John Williams at Shadowstats has it at 21%.
Your earnings analysis has been spot on for the past 6 months, however, unemployment is not done with its upward trajectory yet, when the states get done with their respective cut backs there will be an additional bump to both U3 and U6 and it will be very hard to get that elusive “revenue” growth you mentioned.
Amen.
Why does everyone gloss over the most important part of this US economy, the consumer? 3 million homes to be foreclosed on this year (low estimate). House sales dropping again and steadly (though prices went up, but doubt that will last). The give aways are about to end (though likely get renewed even though the liars, errr, politicans said they wouldn’t). If you look at bank closures this year it’s so far way out pacing last year.
If you use meaningless, heavily manipulated to look good, government numbers I guess you can see things stablizing at best. But you keep using the word recovery like you’ve been paid to do so is getting old and tiring. But the far more realistic U6 numbers (you know, what we used before Kennedy) things are not looking hot.
Here in Northern Washington state I hadn’t seen a foreclosure sign until 2 weeks ago when 5 popped up in my neighborhood (+/- 6 blocks). So it seems like people’s ATMs (their houses for those who don’t know) are about to double dip. I’d say 15% or more to try and get to where it’s fair market value. But with treasury auctions not doing so hot for 10 year the price of a mortgage is going up.
The bond markets now believe Lowes has a better chance of repaying it’s debt then the US government who can print limitless money. This isn’t a great vote of confidence.
Thankfully cash (USD) will be king for a bit yet. I think at this point we should stop using recession/recovery and use the proper term. Depression.
Keep on keeping on. I enjoy the site even if I don’t always agree 100%.
I am not signaling an all clear for the economy. But it is a fact that the unemployment situation is contributing to the bottom line via lower unit labor costs.
The ISM data, jobless claims data, recent NFP all show improvement (albeit marginal in the grand scheme of things). This means firms are well positioned for any recovery should it occur. It also means the fat margins are here for now. Perhaps most important, it means companies are seeing stronger revenues because they are increasingly spending on hiring, etc. These are public facts I am reporting. Nothing more.
Very nice summary. Based on some of your charts, it looks like 2005 with a sideways economic outlook. Fair value +/-. Don’t expect great things from the broad market.
great post
just as an aside, tpc, most other financial bloggers do not just watermark their charts with their sitemark, as you do, but also set forth the source of the data that went into the construction of the chart. do you have any opposition to identifying source material? (i understand that your expectation ratio chart should be exempt from this request).
your analysis makes my bullish case with a hair trigger on the sell button better than i could make!
Great call on the banks Chris. You nailed this one. They’re up over 20% in a matter of weeks. Amazing.
Congratulations Chris! Very nice trade. I was totally wrong on this last leg and I paid it (not too much fortunately).
wow, guys, now you have me worried!
i have operated on a thesis, part investment analysis part patriotic belief, that we would close the lehman gap. i have operated on this thesis since 1/09 thinking that it would take 2-5 years.
i was prepared to be patient, especially after i dropped 20% in early 09, because i thought the financial crisis was a classic rothschild “blood in the the streets” moment that i thought i would never see in my lifetime.
if you look at dia or spy, you will see that we have almost closed the lehman gap. if you look at iyf, you will see that we have at least 25% to go.
so, in the face of 0.25% short term interest rates for an extended period of time, reiterated as of this morning, i am continuing to overweight financials and staying long, with 5% stop loss orders.
i do admit that today’s market action is stunning.
He didn’t a “good” call on this at all. He hopped out last Friday when it was down and jumped back in on Monday after it was up. Big f’ing deal. Chris’s “tight stops” are just churning him up. He claims he rode the rally up from March last year, but he’s already told us he has a 1% stop on the banks so we know he’s full of it.
As long those deliquent on their mortgages continue to not make payments, I believe we will continue to have a consumer boost in this market. This can’t be helpful to us down the road, but for right now it will do. As a result I am forced to be bullish under these circumstances.
This is the easiest market I have ever traded. We are just getting pulled up to 1200. Never seen anything quite like it.
Seriously. Someone wants this market over 1200 by the end of the quarter. I can’t remember ever seeing a short squeeze quite like this one where stocks got squeezed every day for over a month.
Someone is getting short squeezed in the banks like I’ve never seen before. This intraday chart is straight up in the air.
I’ve been following this earnings surprise business for a little while, and did a little work on it based on Bloomberg data over the past four or five years. See here and here. If history holds, there will be a preponderance of upside surprises in the US, simply because that’s what always happens, although it’s been more pronounced the past several quarters. In Europe, not so much. Why there is more of a balance between positive and negative surprises in Europe than in the US is a bit baffling, but it’s there.
Keep in mind that the dollar has risen significantly over the last three months. This will surely dampen profits of the S&P companies that have overseas revenue. We may finally have some misses!
I remain highly pessimistic about the long-term direction of the S&P but acknowledge that I was wrong about the timing of the upcoming crash. Uncharted water we remain in.
Covered my shorts today. No use fighting the bankers. We’re going to 1,300 S&P by the end of the year for sure.
you bought some today, danish, i sold some today…now 20% financials, down from 50% this morning…i guess we will agree to disagree
by the way, you never answered my post from last night:
“so you hear the market top bell ringing, do you danish. howsabout you and me make a friendly bet…that the S&P500 close on 3/31 will be higher than the close today, 3/24.
are you game?”
so are you game or are you out of the game?
What kind of stupid investor are you? You come on here with your day trading picks and talk about how you flipped out of banks on Friday and jumped back in on Monday and now you’ve cut the position down to almost nothing.
You’re a day trader Chris and no one gives a damn about day traders. Who cares where the S&P closes next week. Anyone who thinks they can predict that kind of a move is a fool.
i take it the answer is no bet.
as for day trading, i don’t do it.
i have been net long exactly 93% of the time since 1/09 (i keep a journal), never holding less than 10% cash, usually holding 20% cash; as of 2pm today, i am holding 50% cash. i went 100% cash twice since 1/09 because of political fears, and when the market told me not to worry, i went back long. i keep tight stops so the market never surprises me and i always know the maximum amount i can lose at any one time. i am overweight financials because the yield curve and ben bernanke tell me to do so. i also short, but not with relish (euro and long-dated treasuries).
now if that is day trading, then i will be a monkey’s uncle.
Well all we have is your record while you’ve been here and thus far you look like a day trading monkey.
Do you honestly believe that you can predict where the S&P will finish each week or day? If you could do this you wouldn’t be hanging out on some website all day.
DanH,
Chris has made some good calls while he’s been here and his bullish thesis has been correct.
Leave it be.
the last 10 minutes of a 2 hr easter egg hunt are always the toughest,
http://www.businessinsider.com/the-worlds-largest-shipper-isnt-sold-on-the-trade-recovery-its-balanced-on-a-knifes-edge-2010-3?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+clusterstock+%28ClusterStock%29&utm_content=Google+Reader
this week is the IPO pump and dump, got a reentry swimg signal on 9 Feb and preliminary sell last Thurs; I’ll leave the exact tops on bottoms to fools, drunks, and liars…
danish, you told the world yesterday that you could predict prices, that’s why i called you out and posed the bet.
you said this yesterday: “And they say they don’t ring a bell at the top. Ha.”
that was 1% down ago. you still hear that bell ringing?
sorry tpc, i don’t back down (or do so only when i am wrong), but i guess you knew that.
enough…*tosses away his brash and brazen side*
Lots of nervous people around…
It’s the bulls who are nervous now….
true, but it is a good nervous…
We’ll see Chris. I would argue that your big jobs number is 1) priced in and 2) bad for keeping rates low. I would also argue that a good earnings season is now widely priced in.
What you’re overlooking is the fact that the Euro is under serious fire and will cause massive problems in Europe and that the Chinese market is now completely rolling over as investors fret the monetary tightening that is occurring.
No one is focused on the China story, but don’t be shocked if it blind sides you in the next month or so….Everything else you refer to is widely known….
“I would argue that your big jobs number is 1) priced in and 2) bad for keeping rates low. I would also argue that a good earnings season is now widely priced in.”
as to 1, you may be right, but i still think the first positive number in over a year will have a positive confirmatory effect, mostly on consumer sentiment, that the recovery wont double dip, it is ok to start allocating more to equity funds and less to bond funds etc, and if the print is as big a delta as some think, i think it will be positive boost for the market. we’ll see soon enough.
as to 2, i just plumb disagree…i was listening to bernanke pretty closely today, and he is looking at (core) inflation, not jobs, as a trigger to tighten. inflation will lag a turnaround in employment, so i have my eye on inflation, not jobs. i would view any dip on a good employment print as a cause to sniff and maybe buy.
i find china opaque, even after i devote a fair amount of time studying it. my best guess is that the yuan will be set free to rise just a bit soon, because china is slowly beginning to look at the world as both an importer and exporter. i confess that i may be wrong on china because i can’t get a firm grip on it.
the market is very high, without a doubt, in anticipation of a good earnings season, as you say, but my market, financials, still has a ways to go, imo…except if 1Q bank numbers disappoint…in which case i will day trade out of financials quicker than a monkey’s uncle.
China = the next great superpower.
The end of the US empire is nigh. We’re out of bullets to fight the double dip. They’re on the cusp of being the next great economic power. However, I wouldn’t buy any stocks at these levels.