Revisions Ratios Tumble

Looking forward to the second quarter, the median expectation is for 8.9% growth, which easily puts it within range of double digits given anything like a normal surprise performance. In each of the last five quarters, the median firm reported earnings that were over 3% higher than expected. So it is not unreasonable to think this streak may continue to 20 quarters. While the 10.1% growth is still lower than previous quarters it is much better than expected.

The surprise ratio for first-quarter earnings is 2.9:1, unchanged from last week, and given how few firms there are left to report it should be about the final number. Positive surprises have been widespread, with every sector showing more positive surprises than disappointments with the exception of Utilities, and the Utilities are tied. Three sectors have all their reports in and five others are more than 95% in. The only sector with a significant number of reports yet to arrive is Tech. So far 329 firms have reported positive earnings relative to a year ago, eleven posted flat earnings and 141 posted earnings lower than a year ago.

Material, Utilities and Health Care continue to hold gold, sliver and bronze in the growth race. It is a very tight race at the top, with just Materials and Utilities virtually tied for the top spot. However, Health Care appears to be the real standout so far this quarter, posting 13.9% year-over-year growth with 41 positive surprises against only seven disappointments, or a surprise ratio of 6.8:1. The median surprise is a very strong 5.6%. Health Care is also the only sector among the leaders that is expected to see growth accelerate in the second quarter. Tech and Consumer Discretionary are also expected to see an acceleration, but they were far from being leaders in the first quarter. The Materials sector is also having a very robust quarter, with 14.5% year-over-year growth and positive surprises outnumbering disappointments by more than 3:1. However, its median surprise is somewhat below average at 2.52%. Telecom is the only sector showing negative year-over-year growth (-6.7%) and its surprise ratio is just 4:3, but it does have a large 5.33% median surprise. Funny things happen when you have a small sample size. Tech also appears to be a laggard in the first quarter, with a median earnings growth of only 3.8%.

It is worth noting that the results so far have been much stronger for the S&P 500 than the S&P MidCap 400 and the S&P SmallCap 600. Large-caps have been much more active in shrinking their share bases through stock buybacks than have their little brothers, and they also tend to have more foreign exposure and thus benefit from the very weak dollar. Some might question the quality of earnings coming from those sources. Also among the banks, several have been reporting sharply higher non-performing loans, but not raising their Loan Loss Reserves. The quality of those earnings is also questionable.

The Zacks “Revisions Ratio”

To help gauge the direction of the market, we take note of what analysts are thinking. By tallying their EPS changes, we can determine our “revisions ratio.” This ratio simply divides the total number of positive estimate revisions by the total number of estimate cuts. Thus, a high ratio is a bullish indicator and a low ratio is bearish. For the S&P 500 as a whole, a number below 0.80 or above 1.25 is generally significant. For individual sectors the distance from 1.0 should be greater for the numbers to be significant.

For fiscal 2007, the revisions ratio stands at 1.21, down significantly from 1.56 last week. Over the last four weeks, there were 945 upward EPS revisions and 779 downward, for 1,724 revisions total. This is down 43% from a week ago. We are clearly past the quarterly peak of estimate revisions activity. Don’t look for analysts to get real busy changing their estimates again for another six weeks or so. Remember that these are moving four week totals, so last week’s reading is not totally independent from this weeks (three weeks of overlap).

Upward revisions were less widespread than they have been in recent weeks. The strong showings for individual sectors in terms of both growth and positive surprises seem to be already reflected in positive estimate revisions posted in prior weeks. Health Care continues to lead the pack with over twice as many upwards revisions as cuts. Industrials, Financials, Telecom and energy all enjoyed more than three increases for every two cuts. Last week the S&P 500 as a whole was above that ratio. The Consumer Discretionary sector continues to be the laggard with a revisions ratio of 0.60. This week it is joined in the below one club by Materials and Consumer Staples. The overall ratio of firms with rising estimates to falling mean estimates moved down to 1.14 from 1.20 last week, and 1.38 two weeks ago. Consumer Discretionary was also the only sector with more firms facing declining mean estimates for 2007 than increasing estimates.

The 2008 revisions ratio is 1.30, down from 1.60 last week and just above the 2007 ratio. The total number of FY2 revisions over the last month was 1,459, down materially from last week. As with 2007, the Consumer Discretionary and Consumer Staples sectors were weak. Materials was relatively weak, but still enjoyed more increases than cuts. The Industrials sector was far and away the strongest with more than seven increases for every two cuts. Unlike 2007, positive first quarter surprises have no direct impact on 2008 earnings. The strong preponderance of upward revisions therefore indicates better expected fundamentals going forward. The overall ratio of increasing to decreasing firms was 1.47, up from 1.56 last week. This is still a strong reading indicating widespread upward revisions. Analysts remain quite sanguine about the prospects for earnings both for this year and next.

Full Year Growth

On a full-year basis¹, median earnings growth for the S&P 500 is expected to remain healthy. On a total basis however, growth is expected to slump into the high single digits for 2007 and then rebound in 2008.

There are a couple of technical points which are affecting the expected growth rates. Recently firms have been pumping enormous, and unprecedented, sums into share repurchases. In 2006, over $432 billion was spent by S&P 500 firms to buy back their own stock. These buybacks amount to 3.4% of the S&P 500’s year-end 2006 value and have the effect of increasing 2006/2005 growth rates by approximately 3.5%. All indications are that buybacks will have a similar effect on 2007 earnings growth.

Looking on a somewhat longer perspective, expectations for growth have come down just slightly over the last three months. The median S&P 500 firm is currently expected to show growth of 11.2% for 2007, down from 11.9% growth three months ago. For 2008, the expected growth unchanged at 12.3% over the same period.

On a total earnings basis, growth is expected to show a far sharper deceleration in 2007 than on a median earnings basis. Total earnings are expected to be 8.1% higher in 2007, following 15.3% growth in 2006. Next year total earnings growth is expected to rebound to 11.5%. All three of the sectors which posted greater than 20% growth in 2006 on a total earnings basis are expected to see growth fall to the single digits. Two sectors, Consumer Staples and Technology, are expected to see noteworthy earnings acceleration in 2007 that is expected to carry over into 2008. In the Materials and Energy sectors, growth measured on a median basis is far healthier than if measured on a total earnings basis, which is in large part due to the concentration of a high percentage of the total earnings for the sector in a few firms in those sectors.

Market Cap versus Total Earnings

When making investment decisions, growth should always be looked at in conjunction with how much you are paying for a stock. Thus, it makes sense to look at the total earnings expected for a sector, relative to that sector’s total market capitalization. This is basically a variation on looking at the P/E.

The chart below shows the share of total earnings for 2006, 2007 and 2008, as well as the share of total market capitalization for each sector (the final bar shown). Since the S&P 500 is a market cap weighted index, this is the same as its index weight. On the chart below, the difference between the sizes of the first three bars shows if a sector is gaining or losing “earnings share”. The difference between the final bar and the first three bars shows if the sector is selling for an above or below market P/E. If the final bar is smaller than the other bars, the sector is selling for a below market P/E. However, as opposed to just showing the sector P/Es, it also shows the relative importance of the sectors to the overall index.

Clearly the Financials are the biggest influence on the market. However, that sector is also relatively cheap on an earnings basis, and thus serves to hold the overall P/E of the index down. In other words, Financials deserve to be the biggest influence on the market, since they contribute approximately 27% of the total expected earnings for 2007.

Energy looks to be under represented in its influence on the market since it is expected to provide 13.7% of the total earnings for 2007, but represents only approximately 10% of the total market capitalization of the index. While its earnings share is currently expected to decline to approximately 12.8% in 2008, even on this basis it is still much cheaper than the overall market.

In more conventional terms, the Energy sector is trading for 12.1 x 2007 and 11.7 x 2008 earnings. The S&P is trading for 16.4x and 14.7x, respectively. The second chart below shows the sector P/Es ranked from lowest to highest based on estimated 2007 P/E ratios.

Matt Thurmond contributed significantly to this report.

²We follow the convention of referring to the most recently completed full fiscal year as “2006”, and the next full fiscal year to be reported as “2007”.