In early January I said the back half of the year was likely to be characterized by earnings estimates that are too high. And for the first time in over a year analysts are cutting their estimates right on cue:
“For the first time in more than a year analysts are cutting their forecasts for Standard & Poor’s 500 Index earnings, jeopardizing gains from the biggest September rally since World War II.
Estimates for S&P 500 companies’ combined 2011 profit fell as low as $95.17 last month from an August high of $96.16 and posted the first quarterly reduction since the three months ended June 2009, according to more than 8,500 analyst forecasts tracked by Bloomberg. The revision came as the benchmark gauge for U.S. equities rose 8.8 percent last month, the largest September advance since 1939.”
David Rosenberg of Gluskin Sheff says these estimates are still far too high:
“Indeed, this is the bottom-up S&P 500 operating EPS estimate that is currently driving equity valuations — if you don’t believe it, then go to page 26 of Barron’s (Facing Up to the Real Third Quarter). That would be a 14% gain on top of this year’s anticipated 36% bounce. But here’s the problem, the economy is no longer accelerating, it is decelerating. And to show how a sub-2% real GDP growth can wreak havoc with corporate earnings when margins are close to peaks rather than troughs, the national accounts data show vividly that on a sequential seasonally-adjusted basis, pre-tax corporate earnings (without IVA and CCA) barely rose at all in Q2 (+0.9% QoQ). So continued double-digit YoY growth (the consensus is +24% for Q3) is masking the slowdown evident on a quarter-by-quarter basis.
Here’s the rub: to get that $95 operating EPS for 2011, we either need to see at least 7% nominal GDP growth, which last happened in 1989 when inflation was 5%, not close to zero, or margins manage to reach new all-time highs. We won’t entirely rule this out, but will give it 1-in-25 odds of occurring. All we can say is that the base case is for low single-digit nominal growth and some margin compression so frankly we could be looking at something closer to a $75 earnings stream next year. Moreover, when one slaps on a 10x multiple on that — consistent with the economic uncertainty commensurate with a post-bubble deleveraging cycle — then getting to 750 at some point in the S&P 500 is not at all out of the question.”
Rosenberg is likely correct barring some miraculous economic rebound in 2011. Unfortunately, the many macro headwinds are likely to persist well into 2011. That means the meager recovery in revenues is likely to continue. Thus far, revenues have remained the crux of the economic problem. When sales fell companies were forced to fire workers. Without a strong rebound in revenues there has been no need for hiring. With very low aggregate demand due primarily to the weak consumer, revenues just haven’t rebounded despite a nice rebound in bottom line growth. Currently, revenues per share (S&P 500) are just 6.5% off their trough and 15.5% from their all-time highs:
Companies have been cutting costs at a blinding rate as they protect their profits. The primary input here has been unit labor costs which have declined to their 2006 levels:
The result of this cost cutting has been a remarkable rebound in profit margins. Currently, profit margins are just 1% off their 2006 highs, This has been the story behind the rebound in profits thus far. It has been anything but organic:
This likely means there is more room to cut costs, but we’re reaching a point of stagnation in profit growth. Cost cutting is not a sustainable story and as revenues fail to pick up the slack we’re seeing a vicious cycle develop. The lack of a revenue recovery results in continued cost cutting which results in continued low levels of employment which results in continued low levels of revenues which results in continued low levels of aggregate demand (so on and so forth). Unfortunately, the geniuses at the Fed and Treasury have failed to recognize this recession for what it was – a balance sheet recession and so they have not provided the needed aid to households that might spark a recovery in the consumer. Instead, they focused most of their energy on the banks and the results now speak for themselves.
The upcoming earning season is likely to be reflective of the recent past and this continuing weak trend in revenue growth and continued cost cutting. Q3 should be somewhat similar to Q2 earnings – a generally high level of beats (65% by my estimates) with relatively tepid guidance as the macro economic environment remains difficult and visibility remains poor. My expectation ratio is calling for another solid set of quarterly figures, however, the strong earnings cycle deteriorated in recent quarters and is now trending down. This reflects the very high levels of optimism at the analyst level and the more muted expectations by corporations.
In summary, the market has likely priced in fairly good earnings after the September rally. There has been a distinct trend in recent earnings seasons in which equities have rallied into the earnings season, remained robust through the first few weeks and then sold off as it becomes evident that earnings are clearly priced in and the catalyst subsides. Another strong earnings season is likely on deck, but don’t be surprised if it doesn’t provide much of a boost to a market that has already priced in continued economic recovery.