Continuing to Hack Away at Estimates

There is not that much going on with respect to earnings right now. As of the end of last week, just a single company had formally reported its third quarter results. Estimate revisions activity has also slowed to a crawl, but where there has been revisions, the changes have not been pretty.

Looking forward to the third quarter, it looks like it should be broadly similar to the second quarter in terms of median growth. For the S&P 500 as a whole, 6.23% growth is expected. However if you factor in about a 3% positive surprise then we are roughly inline with the second quarter.

In terms of sector performance, the general rank ordering is similar. Energy is expected to far out perform all other sectors with growth of 33.3%. Then there is a tight grouping of Industrials, Health Care and Tech between 10.3% and 11.8% growth. Financials (-10.4%) and Consumer Discretionary (-1.5%) are once again expected to be the weakest performers.

This week, we also provide our first peak at the expected growth rates for the fourth quarter. Here the overall picture looks much stronger than the third quarter, with an expected median growth rate of 11.8%. This is mostly a function of extremely easy comparisons in the Financial sector. Recall that in the fourth quarter of last year the sector as a whole was bleeding red ink. Given those super easy comps it is surprising that the sector is only in fourth place for fourth quarter growth at 12.2%, trailing Energy (+34.7%), Health Care (+14.5%) and Industrials (+13.4%).

Some of the factors which should help median EPS growth are share repurchases, which though have slowed in recent months, will still reflect what happened last year. The share repurchase totals have not been released yet for the second quarter, but in the first quarter, S&P 500 firms bought back $113.9 billion, following $141.7 billion in the fourth quarter.

For a sense of scale, total reported earnings (not the same as the operating earnings before non-recurring items that we track) for the S&P 500 were $135.2 billion in the first quarter and $68.5 billion in the second quarter. The repurchase numbers are gross, not net of share issuance, and in recent quarters many firms, particularly in the Financial sector have been issuing stock to bolster their balance sheets. Oddly, increased share counts will also help boost EPS among the Financials. Since the ones that have increased their share counts the most (by going hat in had to the sovereign wealth funds looking for new capital) are also the ones that are likely to reports losses, so the loss per share will be less.

In addition, to the extent that firms have large operations overseas, they should benefit from the currency translation effects of the weak dollar. The weak dollar has also boosted those companies that export a substantial portion of their sales. With the recent rebound in the dollar, that effect will fade somewhat, particularly the currency translation effect. The revenue effect of U.S. firms being less competitive overseas due to the dollar rebound is more likely to affect the fourth quarter than the third.

Keep in mind that median growth rates are inherently equally weighted, so the growth rate for Cabot Oil and Gas (COG - Analyst Report) is just as significant to the results for the Energy sector as the growth rate for Exxon (XOM - Analyst Report).

Total Net Income Growth

In regards to the third quarter, it looks like we will have another down quarter, but not anywhere near as ugly as the last 3 have been. Currently a 2.98% decline is expected. At a similar point before the second quarter earnings season, the expected decline was 9.7%, rather than the 21.0% decline we actually experienced. While I expect a better (less worse) earnings season for the third quarter than we had in the second, I don’t think the improvement will be that dramatic.

All of the improvement (such as it is) is expected to come from two sources.

The Financials are expected to suck just a little bit less (don’t count on that happening) with a decline of 49.8% from a year ago. While that is ugly, it represents a significant improvement over any of the last 3 quarters where the declines ranged from -78.4% to -119.8%. However, many will have to write off their holdings in Fannie and Freddie preferred, and who knows how much damage will have to be recognized due to Lehman Brothers. Given the continuing estimate cuts for the sector, that sort of improvement seems optimistic.

To a lesser extent, there is also a less severe decline expected for the Consumer Discretionary sector, with only a 32.8% drop, rather than the 66.8% year over year drop it suffered in the second quarter. However, Financials are a far larger sector and thus will have a much more significant effect.

Energy is expected to post eye popping growth of 49.5%, which will be a very tall order indeed, especially with oil prices slipping in recent weeks. Note below that estimate revisions for the Energy sector have now turned negative. Materials are expected to post the second largest increase in net income at 14.5%, but that is a fairly small sector. Anemic low- to mid-single digit growth is expected for all other sectors.

On the plus side, that does not seem like that big a hurdle. We may be setting up for many positive surprises in the third quarter.

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. With smaller totals for any given sector than the S&P 500 overall, the ratio should be farther away from 1.0 to be truly significant. However, for the sake of consistency, we refer to readings above 1.25 as being in positive territory and below 0.80 as being in negative territory.

The effect of second quarter surprises has almost totally worn off, and with it the boost we saw to the revisions ratio. With the total number of revisions now falling, so is the ratio of increases to cuts. The ratio posted a dramatic drop into negative territory this week. It is now at 0.56, a reading that is still neutral, but down from 0.84 last week and 0.95 two weeks ago. This means that for the S&P 500 as a whole, there were almost twice as many estimate cuts as there were increases. That is one ugly number, the only real consolation in it is that we are in the slow season for revisions overall. Over the last four weeks there have been 1,112 changes in estimates: 399 up and 713 down, down 19.4% from 1,380: 628 up and 752 down last week. The ratio of firms with rising mean estimates to falling mean estimates is 0.62, stronger than the revisions ratio, but also deep in negative territory.

No sector was in positive territory this week. That has not happened in a very long time, although three are still above the 1.0 level. Utilities and Financials are battling for the title of the worst, with revisions ratios of 0.16 and 0.15 respectively. However, the utility number is based on a very small sample of just 22 total estimates so the reading is much less significant that the Financial sector reading that is based on a total of 193 estimates. Consumer Staples, Energy and Tech were all solidly in negative territory as well.

The revisions ratio for 2009 is even weaker than for 2008. It fell deeper into negative territory with a reading of 0.51, down from 0.71 last week, and 0.78 two weeks ago. These sorts of cuts will start to dig into the robust rebound in profitability that is currently expected for 2009 (up 27% on a total earnings basis, and 10.7% on a median EPS growth basis). The strong net income number is almost entirely a function of the Financials not continuing to implode in 2009.

Only the Materials sector is in neutral territory and then just barely with a reading of 0.82, and that is on a total of 31 estimate changes. Utilities captured the bottom spot but also on a low volume of estimate changes.

The total number of revisions for the whole S&P 500 for 2009 is also continuing it seasonal plunge. There were a total of 1,022 revisions: 347 up and 675 down. This is down 16.4% from 1,223 (506 up and 675 down) last week. The ratio of firms with rising mean estimates to falling mean estimates is 0.51, identical to 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.

For years, the Financials were the dominate force in the market, both in terms of market cap, and even more so in terms of total earnings. They have now been decisively dethroned on both counts. On the Market cap front it is in second place. However, it has now slipped into sixth place based on 2008 earnings. Still, despite their current problems, the Financials are still a very significant influence on the market.

Even with all the disasters in the sector, for 2007, the Financials accounted for 22.0% of the total net income for the S&P 500. In 2008, that is currently expected to decline to 7.5% before rebounding to 17.1% in 2009. However, in recent years the sector has accounted for well over a quarter of all earnings.

Energy has usurped the crown this year, with its earnings share climbing to 22.4% from 15.6% in 2007. Energy should keep the earnings crown for 2009 as well, gathering 19.9% of all the earnings of the S&P 500.

On the market cap (and index weight) front, Tech overtook the Financials a few months ago and currently stands at 16.4%. The Financials still account for 15.2% of the index. Energy has the 5th highest weighting at 12.4%. There is thus a huge disparity between the market share weights and the earnings weights for the Financial and Energy sectors, with Energy being extraordinarily cheap and the Financials extremely expensive.

Keep in mind that these numbers are snapshots, when you should be thinking about a movie. At the end of February (the first time we had a complete read on 2009), the Financials were expected to gather 22.1% of all earnings for 2008, and Energy was expected to only get 16.0%. For 2009, the expected earnings shares were 15.0% for Energy and 22.4% for Financials. A year ago before the credit crunch hit, Financials were expected to gather 26.3% of 2008 earnings and held a 19.4% weighting in the index. Energy represented just 10.9% of the total market capitalization and was expected to get 12.9% of the total earnings in 2008.

For many years Financials were clearly the dominate factor in the overall market, despite generally selling for below market P/Es. Due to an implosion in earnings that has been far worse than the dismal market performance of the sector, the Financials now have the highest P/Es based on 2008 earnings, displacing the perennial high P/E sector Technology. Based on 2008 earnings, the Financials have a P/E of 30.8x. However, given the expectation that the bleeding will stop next year, the P/E based on 2009 earnings is just 10.6x. 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 has just taken the throne as the cheapest based on 2008 earnings trading at 8.4x, and 7.4x based on 2009 expectations. There is no question in my mind that Energy is the cheapest sector of the market, and every portfolio should be overweight in it. The Tech sector has a somewhat higher than market P/E, trading for 17.8x 2008 and 15.2 x 2009 expectations. The premium to the market is however lower than it has been in some time. Health Care looks interesting trading at 14.2x 2008 and 12.9x 2009 earnings.

Keep your eyes on the revisions, they give you the best clue as to if the earnings will be achieved and if the P/E’s are for real. While the recent declines in oil prices may cause the upwards revisions to moderate for the Energy sector, most analysts are using very conservative price assumptions.

The S&P 500 as a whole is trading for 15.1x and 11.9x, 2008 and 2009 earnings, respectively. Based on a blend of 33% 2008 earnings and 67% 2009 earnings; that translates to a 7.71% earnings yield, which looks extremely cheap relative to a 3.64% ten year T-note. Even against the A rated corporate bond yield of 6.31% 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. The comparison between the earnings yield on the S&P and the 10-year T-note is in my opinion more a reflection of the extreme unattractiveness of long term T-notes at this point than stocks looking particularly cheap in general, however there are attractive stocks out there. It appears that the flight to quality has caused a massive bubble in the price of T-notes. This is far and away, in my opinion, the most significant bubble in the market today. The prices are hard to justify given the risk that the massive injections of liquidity by the Fed to ameliorate the credit crunch will end up fueling the fires of inflation.

Neil Malkin contributed significantly to this report.

Data in this report, unless stated otherwise, is through the close on Thursday 9/11/2008

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