EARNINGS ESTIMATES ARE A MAJOR MARKET HURDLE
Courtesy of The Pragmatic Capitalist
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.
