Forecasts Respond to Positive Surprises

Key Points:

• Total earnings are running 21.9% below last year, but up sharply from Q4
• Financials much are better than expected, but quality of earnings is awful
• Ex-Financials, total earnings are down 28.4% from a year ago and down 15.8% from Q4
• Total net income down in all sectors but Financials, Utilities and Health Care
• Health Care, Tech and Discretionary all showing lots of positive surprises
• Full S&P 500 total net income expected to be 27.2% lower than Q1 2008
• Decline expected to continue in Q2, with earnings down 31.9%
• Total net income expected to fall 14.9% for all of 2009, after 18.9% fall in 2008
• Bottom up estimate for S&P 500 now $57.76 in 2009 versus $59.36 last week.

Total Net Income Growth

First quarter total net income is 21.9% below what the same 289 firms reported a year ago, but 35.0% above what those firms reported in the fourth quarter. However, relative to the fourth quarter, almost all the improvement has come from the "earnings" of the Financial sector. (I put the term earnings in quotation marks due to the extraordinarily low quality of the earnings at the big banks that are driving the turnaround. It is hard to take seriously earnings that are based on mark to market for liabilities but not for assets. However, the accountants have signed off on them, so we include them in the database. )

Excluding the 51 Financial firms that have reported, total net income is down 28.4% from a year ago and 15.8% lower than in the fourth quarter.

Aside from the Financials, only the Utility sector is showing any significant gain in total net income at 6.1%. Health Care squeezes into the plus column, but by less than 0.1%.

Worst hit so far are the Materials (-71.4%) and Energy (-55.9%) sectors. They however are facing some very tough comparisons. The commodity boom was in full swing a year ago, and materials like copper were flying just as high as oil prices were...today, they are not flying quite so high.

The Consumer Discretionary (-54.7%) and Industrial (-37.4%) have also seen large drops in total net income. What do the 4 bad sectors have in common? They are the four most cyclical sectors of the economy.

Leaving aside the special case of the Financials, the 3 sectors that are doing best - Utilities, Health Care and Consumer Staples (-9.2%) - are noteworthy for being non-cyclical. Thus the pattern of earnings growth (or the lack there of) is exactly what you would expect in the middle of the worst economic downturn since the Depression.

The weak earnings are offset by the fact that the bar was set very low this quarter. Brokerage analysts expected Armageddon and we only got a disaster. As a result, positive earnings surprises are outpacing disappointments by a ratio of 2.3:1. The median surprise is a very healthy 4.8%.

Some of the sectors with the worst growth in total net income actually have the highest surprise ratios. In the Energy and Materials sectors positive surprises are running 3.5:1 over disappointments. Consumer Discretionary firms are seeing surprises running 4.3:1 over disappointments.

On the other hand, Health Care is doing even better than any of those sectors with a ratio of 4.8:1.

Scorecard and Median EPS Growth Rates

• Surprise ratio at 2.30, median surprise 4.76% with 289 firms reporting
• Median EPS decline reported so far is 18.1%
• A 12.0% decline is seen in the first quarter for those yet to report
• Positive surprises concentrated in the Discretionary, Health Care and Tech Sectors
• Every sector but Telecom and Health Care is down so far among the reported firms
• Among yet to report, Utilities, Health Care barely positive, the rest negative

We now have over half the reports in and positive surprises are outnumbering disappointments. That is however, mostly because the bar was set very low. Firms learned a long time ago that it is better to under promise and over deliver, so it is quite normal for positive surprises to outnumber disappointments.

This quarter's ratio is actually slightly below what we were accustomed to seeing in recent years. Still, better more positive surprises than more disappointments.

Half the firms have reported declines in EPS of 18.1% or more. Over two-thirds have reported negative EPS growth. Telecom is leading the EPS growth pack, but that is based on the results of only 4 firms. Health Care is the only other sector where more than half the firms are reporting growing EPS, with a median gain of 7.1%.

In 4 sectors, Industrials, Tech, Financials and Materials more than half the firms have seen EPS decline by a third or more.

The Zacks Revisions Ratio: 2009

• Revisions ratio for full S&P 500 is up to 0.65, from 0.51 last week
• Two months ago the ratio was 0.26; the improvement has been steady and strong
• Five sectors above "one"; 4 are in positive territory
• Although still in negative territory, the revisions ratio has risen significantly
• Telecom and Tech lead the pack, both Consumer sectors are also strong
• Energy and Financials still seeing more than 3 cuts for every increase.
• Ratio of firms with rising to falling mean estimates rises to 0.51 from 0.40
• Total number of revisions (4-week total) up to 3,161 from 2,386 last week (32.5%)
• Increases up to 1,246 from 805 (54.8%); cuts up to 1,915 from 1,581 (21.1%)

The revisions ratio improved sharply, but remains in negative territory. (Generally we consider anything below 0.80 to be negative, and anything above 1.25 to be positive.)

Telecom and Tech are now in positive territory, with both Consumer sectors also knocking on the door. This is a very positive sign coming not long after every sector had been deep in negative territory.

Telecom and Technology leads the pack this week. Both Verizon (VZ - Analyst Report) and AT&T (T - Analyst Report) had far more increases than cuts. Within the Tech sector Stocks with very positive revisions activity worth mentioning include Apple (AAPL - Analyst Report), Broadcom (BRCM - Analyst Report), Intel (INTC - Analyst Report) and Texas Instruments (TXN - Analyst Report).

At the other end of the spectrum, Energy and Financials still have estimate cuts swamping increases. Very weak Energy stocks include BJ Services (BJS - Analyst Report) and Anadarko (APC - Snapshot Report). Among the Financials, companies that are noteworthy for their weakness include Keycorp (KEY - Analyst Report) and Suntrust Banks (STI - Snapshot Report).

• The Overall picture for 2010 is similar to that of 2009
• Revisions ratio up to 0.59 from 0.46
• Positive surprises are leading to more upward revisions
• Ratio of rising to falling mean estimates rises to 0.50 from 0.47
• Tech and Staples the strongest; Energy and Utilities the weakest for 2010
• Total revisions activity should peak in a few weeks
• Total number of revisions rises to 2,355 from 1,757 (34.0%)
• Estimate increases rises to 577 from 480 (20.2%); cuts rise to 1,200 from 1,142 (5.1%)
• Energy, Utilities and Financials slammed

The 2010 revisions ratio story is pretty much the same as 2009. A low but improving revisions ratio. Just a month ago the 2010 revisions ratio was at 0.27, now it is at 0.59.

The Industrials sector has shown significant improvement, but still has more than 3 cuts per increase. Not long ago, cuts in the sector were running over 20;1 over increases. The Tech sector is the strongest, with particular strength among semiconductor stocks.

Earnings Shares and P/Es

• P/Es are too low since earnings estimates are too high
• Health Care expected to take earnings crown from Energy in 2009 and keep it in 2010
• Energy's earnings share expected to plunge to 11.9% from 23.7%
• Financials' 2009 earnings share expected to rise to 10.7% from -1.7% in 2008.
• Consumer Discretionary's market cap share far above earnings shares (overvalued?)
• Health Care's market cap is share well below earnings shares (undervalued?)
• 12-month forward S&P P/E of 13.87 equates to earnings yield of 7.21%, which is very attractive relative to 10-year T-note yield of 3.16%, but only mediocre relative to 5.43% A-rated 10-year corporate.
• T-note rates are rising and more realistic earnings yields of near 5.72% based on lower earnings ($50) means the spread, while still attractive, is not overwhelming.

Neil Malkin contributed significantly to this report.

Data in this report, unless stated otherwise, is through the close on Thursday 4/30/2009