Non-Financial Companies Posting Positive Results

Although there has been some improvement in corporate profits over the past week, it still looks like a pretty ugly earnings season. This said, there is a silver lining to the overall dark cloud.

Thus far, median year-over-year growth is running at just 8.6%. Considering that the stock market believed that double digit median year-over-year growth was something just short of a constitutional right, we seem likely to fall short.

Surprises are disappointing as well. In recent years, the normal ratio of positive surprises to disappointments has run about 3.0:1. This time around it is just 2.3:1. The median surprise tells a similar story, currently running at 2.4%, while over the last four years it ended up at 3.0% or better.

The silver lining it is that the worst damage is in the Financial sector and, almost two-thirds of the Financials have already reported. Financials have been responsible for almost half of all the earnings disappointments.

The Consumer Discretionary sector has also been weak, showing median growth of just 2.6%, a surprise ratio of 1.3:1 and a 1.8% median surprise. Add the disappointments in the Discretionary stocks to those in the financials and together the two sectors are responsible for almost two-thirds of the disappointments so far. Put another way, excluding only the Financials, the surprise ratio is running at 3.6:1.

So far the clear winners in terms of median EPS growth have been Utilities and Tech, with respectable showings by the Industrials, Energy and Health Care. Both Tech and Industrials have been doing fantastically well on the surprise front, with surprise ratios of 7.4 and 29.0 respectively and median surprises of 8.6% and 2.9%, respectively. Put another way, those two sectors are responsible for 38.4% of the total positive surprises and only 7.9% of all disappointments.

Looking at the expectations for those who are yet to report, there should not be major changes to the sector rankings. Utilities and Energy could drift down a little and Financials might dig themselves out of the hole a bit, but overall those that have been strong so far are expected to stay strong and the weak to remain weak.

Total Net Income Growth

The median year-over-year growth discussed above is actually the good news, as things look far worse on a total net income basis. On a total net income basis, the fourth quarter can be summed up in a single word: UGLY. While there has been a substantial improvement over the last week, it still is by far the weakest quarter we have seen in a long, long time. Total net income reported so far is 29.0% below year ago levels, although that is much better than the 41.9% decline we were seeing last week and the 99.1% decline two weeks ago.

Since the most troubled sector, Financials, have seen a higher percentage of its firms report than the S&P 500 overall, the number should continue to climb out of the hole it is in. We would note that the numbers shown below do not include the very strong earnings posted by Exxon ( XOM - Analyst Report ) and Chevron (CVX) reported on Friday morning.

On a median basis, the reporting firms are showing positive growth in earnings, just less positive than in previous quarters, on a total net income basis, earnings are plunging. Looking at all 278 firms that have reported, collectively they posted profits of $93.0 billion this quarter, down from the $132.4 billion they reported a year ago. However it very much looks like a tale of two markets, with Tech doing well and Financials doing awful.

Collectively, the 58 Financial firms that have reported so far are in the have lost $8.4 billion, a year ago those same firms earned $43.5 billion. Noteworthy firms in the red include Countrywide Financial (CFC), SLM Corp ( SLM - Analyst Report ) , Washington Mutual (WM), and perhaps most troubling of all Ambac (ABK) and MBIA ( MBI - Analyst Report ) . These numbers do not include non-recurring items, although parsing out when loan losses are non-recurring in the Financials is problematic at times. Throw in the non-recurring items makes the total losses reported so far, much higher. Telecom is leading the pack but that is artificially boosted by the AT&T/Bell South ( T - Analyst Report ) merger a year ago, also just two of the nine firms in the sector have reported so far. Tech so far is up 30.5%, while that might decline a little bit as expectations for the remaining firms stand at 15.9%. That sure beats a sharp stick in the eye. It certainly appears that Tech will be one of the bright spots for the quarter.

The Energy numbers include 15 stocks, and so far it looks pretty good with 14.3% growth. The numbers do not include the two most important firms Exxon and Chevron, both of which reported better than expected results after we closed the books on the numbers for this report. However, they should not change the picture significantly since together their net income rose by 14.5%.

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.

This, so far is looking like the story of the dog that didn’t bark. While last week, one could have possibly chalked that up to timing differences between companies reporting and analysts changing their numbers, that case is getting harder and harder to make. Outside of Finance and to a lesser extent Consumer Discretionary, earnings surprises have been very positive.

The normal reaction by analysts to a positive earnings surprise is to raise estimates for future periods. This does not seem to be happening this time. The revisions ratio for 2008 is 0.51, indicating about two estimate cuts for every increase, is up ever so slightly from 0.45 last week, and 0.44 two weeks ago.

The total number of revisions is starting to rise. Over the last four weeks there have been 2,469 changes in estimates: 829 up and 1,640 down, up 39.0% from 1,776: 552 up and 1224 down last week. As earnings season gets into full swing over the next few weeks, the totals will climb significantly from current levels, most likely topping 3,000.

By far the sector that is faring the worst is the Financials where cuts out number increases by almost 6:1. Banks continue to get slammed, with double digit numbers of estimate cuts (and no increases) at firms like SunTrust ( STI - Analyst Report ) , Marshall & Iisley (MI), Fifth Third ( FITB - Analyst Report ) and Wells Fargo ( WFC - Analyst Report ) .

Consumer Discretionary follows with a revisions ratio of 0.23, or more than four cuts per increase. However it is striking that only one sector, Health Care, is clearly in positive territory, and a less than 3:2 ratio is hardly overwhelming. It is extremely troubling to see sectors like Industrials, with 29 positive surprises and only a single disappointment have more estimate cuts than increases. In normal times a surprise ratio of that magnitude would lead to a revisions ratio of well over 2.00. Count this as a major vote of no confidence by the analysts in the earnings prospects for companies going forward. Note that the ratio of firms with rising mean estimates is 0.52, virtually identical to the revisions ratio.

The early look at 2009 revisions shows that analysts are already revising their estimates downward on balance for the year, and at almost the same rate they are doing so for 2008. The overall revisions ratio is 0.50, up from 0.50 last week.

As with 2008, the defensive Health Care sector is doing relatively well, while the pictures for the Financials and Consumer Discretionary sectors look bleak. In particular, the retailers are taking it on the chin (keep in mind that these firms generally have non December fiscal year ends, so the end of FY2 is much closer for them than for most firms). Firms with at least 10 cuts and no increases include Bed Bath and Beyond ( BBBY - Analyst Report ) , Family Dollar ( FDO - Analyst Report ) , Kohl’s ( KSS - Analyst Report ) and Target ( TGT - Analyst Report ) . However, the total number of revisions for the whole S&P 500 for 2009 is still relatively light, but are picking up, at 1,113: 395 up and 718 down. This is up 36.3% from 816 (272 up and 543 down) last week.

Keep in mind that the numbers for some of the individual sectors are still very light. As with the FY1 numbers, the ratio of firms with rising mean estimates to falling mean estimates (0.54) confirms the revisions ratio.

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 2007, 2008 and 2009, 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.

Despite their current problems, the Financials are still a very significant influence on the market, accounting for a much larger slice of the earnings in each year than any other sector. Even with all the disasters in the sector, for 2007, the Financials will account for 22.1% of the total net income for the S&P 500, and 22.6% in 2008. However, in recent years the sector has accounted for well over a quarter of all earnings. Thus even though the sector is the cheapest on a P/E basis, it just reclaimed it throne as the biggest total market cap sector (it is in a virtual tie with Tech). The Financial sector makes up 18.2% of the total market capitalization of the index, followed by Tech at 16.1%. The surprise rate cut clearly caused the Financials to rally far more than the market as a whole. However, given the ongoing massive cuts in estimates, please take the P/E on the Financials with a bag of rock salt. The true earnings are likely to be far lower than current estimates now suggest.

For many years Financials were clearly the dominate factor in the overall market. Based on 2008 earnings, the Financials have a P/E of only 11.3x and based on 2009, only 10.0x. However given the pace of estimate cuts in the sector, the true P/E is probably higher since the actual earnings will be significantly lower.

Energy is even cheaper based on 2008 earnings, trading at 10.6x, although Financials reclaim the cheap throne based on 2009 earnings (10.0 vs. 10.4). Unless the spreading of economic weakness to the rest of the world causes oil prices to plunge, you can have much more confidence in Energy earnings forecasts actually being achieved than is true with the Financials. However, Energy is a fairly distant fourth when it comes to total market capitalization (and thus weight in the index) at 11.8%. Health Care is in third for market capitalization at 11.9% and 11.4% of total earnings for 2008 and 11.5% for 2009. It is instructive to look at where the expected earnings shares were at the start of 2007, as well as the market cap shares at that time. Much has changed during 2007, and it is likely that much will also change in 2008 as well. At the start of 2007, the Financials represented 21.9% of the S&P 500 total market capitalization and were expected to provide 26.9% of the total earnings.

The S&P 500 as a whole is trading for 14.0x and 12.6x, respectively. Based on 2008 earnings, that translates to a 7.14% earnings yield, which looks extremely cheap relative to a 3.58% ten year T-note. Even against the A corporate bond yield of 5.27% it looks attractive. However, the current level of expectations for corporate earnings still implies that profits will stay well above their historical averages as a share of GDP. That would be an exceedingly rare occurrence during a recession.

Neil Malkin contributed significantly to this report.

Data in this report, unless stated otherwise, is through the close on Thursday, Jan 31.