Estimates Cut, Again

Key points:

• Positive surprises leading negative, but sample size is small
• Net income expected to fall
• Highlighted stocks include Cabot Oil and Gas (COG - Analyst Report) and Exxon (XOM - Analyst Report)

Earnings Season Has (Officially) Begun

Earnings season is finally underway with 34 of the 500 firms in the S&P 500 have reported. The median year-over-year growth rate currently stands 6.8%. The median surprise stands at +2.15% and positive surprises lead disappointments by a 3:2 margin.

Both measures are well below the "normal" levels, but it is still early and due to the small sample size those numbers will fluctuate significantly as each additional company reports.

More important than the reported results so far are the expectations for the 466 firms that have not yet reported. The median expected year-over-year growth rate for those firms is a gain of 10.53%, which given the historical propensity of more firms to report positive surprises than disappointments leaves open the possibility of double-digit median EPS gains.

Best expected results:

• Energy: 25.9% growth
• Technology: 21.6% growth
• Industrials: 16% growth
• Telecom: 15.5% growth

Not surprisingly Financials are expected to post the worst performance with a 15.1% decline. These numbers seem optimistic to me across the board given the current environment. However, they may reflect somewhat better economic conditions in July and August than we face today. (Going forward, the Financial sector’s prospects will depend on how the bailout on other measures are actually implemented.)

Looking ahead to the fourth quarter, we benefit from very easy comparisons, but even that might not be enough to make things look good. Credit markets are frozen more solid than Greenland (it is still frozen isn’t it?), and that will spread the pain far beyond lower Manhattan the longer it persists.

The Financials will face extremely easy comparisons in the fourth-quarter, but given the magnitude of the current problems, even that might not be enough to make them look good (although based on current expectations they will, but estimate revisions activity is still sluggish).

Third-Quarter Scorecard (Reported)
Sector	Q3 08 Median Growth Rep.	Q4 08 Median Proj. Growth.	2007 Median Rep. Growth	2008 Median Proj. Growth	% Reported	Median % Surprise	# Pos Surprise	# Neg Surprise	# Match
Materials	20.57%	28.08%	36.69%	-1.63%	6.67%	16.37%	1	1	0
Cons. Disc.	11.96%	4.55%	7.51%	2.16%	13.58%	0.00%	5	4	2
Tech	10.53%	2.50%	10.64%	16.72%	9.46%	0.00%	3	3	1
Cons. Stap.	9.09%	5.56%	10.87%	11.26%	19.51%	2.45%	6	1	1
Industrial	-11.08%	0.59%	-5.25%	-3.35%	3.51%	1.61%	1	1	0
Financial	-41.19%	39.00%	-25.54%	-26.84%	4.76%	0.74%	2	2	0
S&P 500	6.83%	4.29%	7.47%	8.74%	6.80%	2.15%	18	12	4

Third-Quarter Yet-to-Report
Sector	Q3 08 Proj. Growth	Q4 08 Proj. Growth	2007 Rep. Growth	2008 Proj. Growth	2009 Proj. Growth
Energy	25.91%	29.81%	13.31%	27.99%	15.64%
Tech	21.59%	8.57%	19.13%	13.84%	14.77%
Industrial	15.96%	12.85%	17.42%	12.96%	13.19%
Telecom	15.52%	1.22%	-2.94%	7.01%	8.43%
Healthcare	14.29%	14.47%	16.98%	12.81%	10.79%
Cons. Stap.	11.11%	9.20%	11.30%	10.44%	10.79%
Utilities	8.18%	6.07%	9.18%	5.68%	10.79%
Materials	6.69%	7.35%	12.94%	5.38%	10.79%
Cons. Disc.	-4.48%	2.38%	7.97%	3.15%	10.79%
Financial	-15.08%	11.48%	6.87%	-5.51%	10.79%
S&P 500	10.53%	10.75%	13.23%	9.47%	10.79%

Total Net Income Growth

On a total net income basis, the results reported so far look far worse than on a median EPS growth basis. Total earnings for the 34 firms that have reported are down 25.4% largely due to a 55.9% plunge in the Financials. While it is a very small sample, it is worth noting that this is a much weaker performance than those same 34 firms reported in the second quarter.

Looking ahead to include those yet to report, the expected decline for the S&P 500 as a whole deteriorated to a -10.2% from -8.1% last week, and -6.2% two weeks ago. That is still a dramatic improvement over what we saw in any of the previous 3 quarters.

Note that the figures shown are for the S&P 500 as currently constituted, not the S&P 500 as constituted at the time the previous quarters were reported. The reported declines were much worse.

Growth sectors:

• Energy: 45.6% net income growth (could be overly optimistic)
• Consumer Staples: 5.9% net income growth

The expected decline in the Financial sector deteriorated to -77.1% from -67.9% last week. Personally I will be shocked if when all is said and done the profits are not worse than -100% for the sector.

The early expectations for the fourth quarter are for a huge rebound in earnings with the total S&P 500 net income popping 27.0% due to a swing from losses to profits in the Financial sector. (Notice the large gain under the Q408 column; a percentage gains that is just plain goofy.)

Given recent events, and the current Treasury plan, it is probably almost impossible to get an accurate read on what the earnings for the financial sector will look like. The bailout plan will not affect the third quarter results, but it could have a big impact on the fourth quarter. The timing of these purchases is very much up in the air. The volume of purchases will be growing over the fourth quarter and into 2009.

Total Net Income Growth (Reported)
Sector	Q1 08 Rep. Growth	Q2 08 Rep. Growth	Q3 08 Rep. Growth	Q4 08 Proj. Growth	2007 Rep. Growth	2008 Proj. Growth	2009 Proj. Growth
Cons. Disc.	-21.24%	-19.40%	35.65%	-1.56%	-19.32%	10.18%	23.56%
Technology	9.79%	23.32%	24.96%	-69.71%	19.96%	22.52%	22.92%
Cons. Stap.	13.76%	11.36%	5.41%	1.40%	21.82%	7.12%	9.62%
Industrial	-4.41%	-22.23%	-19.55%	-3.88%	0.55%	-9.32%	13.77%
Materials	10.33%	6.00%	-38.66%	-1515.20%	37.67%	-3.48%	28.86%
Financials	-59.21%	-36.72%	-55.92%	5556.04%	-13.68%	-39.16%	21.90%
S&P	-35.53%	-20.07%	-25.44%	58.77%	-4.74%	-17.05%	20.64%

Total Reported
Sector	Q3 08 Income	Q3 07 Income	Q2 08 Income	Q2 07 Income
Financials	$3,627	$8,228	$6,889	$10,885
Cons. Disc.	$2,720	$2,005	$1,509	$1,873
Cons. Stap.	$1,917	$1,819	$1,865	$1,675
Technology	$1,857	$1,486	$2,684	$2,177
Industrial	$463	$575	$545	$700
Materials	$280	$457	$1,396	$1,317
S&P	$10,864	$14,570	$14,888	$18,627

Total Earnings Growth: Yet-to-Report
Sector	Q1 08 Rep. Growth	Q2 08 Rep. Growth	Q3 08 Proj. Growth	Q4 08 Proj. Growth	2007 Rep. Growth	2008 Proj. Growth	2009 Proj. Growth
Energy	26.00%	17.56%	45.85%	21.30%	5.88%	35.27%	10.05%
Cons. Stap.	11.21%	0.52%	5.90%	10.83%	10.98%	12.62%	9.11%
Materials	17.77%	4.55%	3.16%	19.99%	9.75%	10.73%	11.16%
Health Care	3.25%	8.64%	1.37%	5.74%	18.96%	9.25%	10.15%
Technology	12.79%	16.60%	0.11%	-0.42%	22.77%	13.55%	16.12%
Utilities	8.90%	3.79%	-0.55%	3.39%	10.39%	6.60%	9.77%
Industrial	6.17%	7.46%	-0.99%	0.90%	12.12%	5.74%	9.39%
Telecom	1.41%	-1.11%	-8.66%	-7.45%	17.66%	11.57%	-3.47%
Cons. Disc.	-18.60%	-63.88%	-28.20%	-26.44%	-4.03%	-18.45%	39.56%
Financials	-75.46%	-79.87%	-82.18%	-592.81%	-20.28%	-63.18%	151.08%
S&P	-10.60%	-15.82%	-9.03%	25.72%	3.75%	-1.54%	21.88%

Total Earnings Growth: Combined
Sector	Q1 08 Rep. Growth	Q2 08 Rep. Growth	Q3 08 Proj. Growth	Q4 08 Proj. Growth	2007 Rep. Growth	2008 Proj. Growth	2009 Proj. Growth
Energy	26.00%	17.56%	45.85%	21.30%	5.88%	35.27%	10.05%
Cons. Stap.	11.45%	1.43%	5.85%	9.88%	11.93%	12.10%	9.16%
Technology	12.57%	17.22%	1.58%	-4.73%	22.55%	14.23%	16.67%
Health Care	3.25%	8.64%	1.37%	5.74%	18.96%	9.25%	10.15%
Materials	16.43%	4.78%	0.25%	20.82%	13.25%	8.57%	13.56%
Utilities	8.90%	3.79%	-0.55%	3.39%	10.39%	6.60%	9.77%
Industrial	5.90%	6.56%	-1.46%	0.79%	11.80%	5.36%	9.48%
Telecom	1.41%	-1.11%	-8.66%	-7.45%	17.66%	11.57%	-3.47%
Cons. Disc.	-18.95%	-59.29%	-19.67%	-24.19%	-6.14%	-15.06%	37.10%
Financials	-72.12%	-71.42%	-77.06%	-696.90%	-19.09%	-58.58%	114.72%
S&P	-12.86%	-16.18%	-10.21%	27.04%	3.04%	-2.73%	21.80%

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 over all, 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 total number of revisions is low, so is the ratio of increases to cuts. However, the number of revisions is starting to rise, the ratio continues to plunge. The ratio continued its dramatic drop into negative territory this week.

• Current FY08 revisions ratio: 0.26
• Last week’s revisions ratio: 0.32
• Revisions ratio from two weeks ago: 0.40

Across the entire S&P 500, there are almost 4 estimate cuts for 2008 earnings for every increase. This is the lowest level for the revisions ratio in the three years I have been writing Earnings Trends. As the effects of the credit crunch continue to filter through the economy, look for this number to continue to decline.

The only real consolation in with the ugly numbers is that we are in the slow season for revisions overall, although the number is starting to rise. Over the next few weeks the total number of revisions will probably rise to well over 3,000.

Trends in earnings estimate revisions:

• This week: 1,512 revisions (309 up and 1,203 down)
• Last week: 1,295 revisions (311 up and 984 down)

Look for the total number of revisions to more than double over the next month. The ratio of firms with rising mean estimates to falling mean estimates is 0.31, stronger than the revisions ratio, but also deep in negative territory.

No sector was in positive territory this week. Staples were the best of a bad bunch with a reading of 0.59. Telecom was the worst, with an incredible reading of 0.05, with 20 cuts and only 1 increase. There was very tough competition for the worst spot, with five of the ten sectors seeing more than five cuts for every increase.

Avg. 4wk EPSChange (FY08)	Avg. 4wk EPS Change (FY08)	Revisions Ratio	Firms With FY08 EPS Increase	Firms With FY08 EPS Decrease
Consumer Staple	-0.65%	0.59	15	24
Industrials	-0.65%	0.54	20	31
Utilities	-0.14%	0.48	8	13
Health Care	-1.50%	0.44	15	26
Consumer Disc	-1.26%	0.30	13	56
Energy	2.61%	0.17	8	31
Financial Services	-3.59%	0.17	16	63
Technology	-1.32%	0.16	4	60
Materials	-2.51%	0.13	3	25
Telecom	-0.88%	0.05	1	5
S&P 500	-1.24%	0.26	103	334

The revisions ratio for 2009 is even weaker than for 2008. It fell deeper into negative territory with a reading of 0.21, down from 0.28 last week, and 0.37 two weeks ago. In other words, cuts are now leading by almost 5:1 to one versus. less than 3:1 just 2 weeks ago.

These sorts of cuts will start to dig into the robust rebound in profitability that is currently expected for 2009 (up 21.8% on a total earnings basis, and 10.7% on a median EPS growth basis). However, if the numbers for 2008 plunge faster than for 2009, then the growth number will go up. The strong net income number is almost entirely a function of the Financials not continuing to implode in 2009 (or at least imploding less than in 2008, total earnings will still be 27.8% below 2007 levels for the sector).

No sector even comes close to making it into neutral territory. The best of the worst was Utilities with a reading of 0.52, just barely beating out Staples at 0.51. In every other sector there were more than 3 cuts for every increase. (In 6 sectors it was more than 4:1 and in 4 sectors above 5:1).

The total number of revisions for the whole S&P 500 for 2009 is also starting to rise. Or to be more specific, the number of cuts is rising while the number of increases is continuing to fall:

• This week: 1,368 revisions (240 up and 1,128 down)
• Last week: 1,149 revisions (250 up and 899 down)

The ratio of firms with rising mean estimates to falling mean estimates is 0.24, a little bit stronger than the revisions ratio, but still ugly.

Avg. 4wk EPSChange (FY09)	Avg. 4wk EPS Change (FY09)	Revisions Ratio	Firms With FY09 EPS Increase	Firms With FY09 EPS Decrease
Utilities	-0.49%	0.52	8	13
Consumer Staples	-1.38%	0.51	10	29
Health Care	-0.15%	0.31	16	20
Industrials	-1.56%	0.26	12	41
Energy	-2.98%	0.24	6	33
Consumer Discr	-2.90%	0.22	15	55
Technology	-2.77%	0.18	4	62
Financial Services	-4.09%	0.13	9	73
Materials	-2.97%	0.09	3	24
Telecom	-3.80%	0.05	1	6
S&P 500	-2.39%	0.21	84	356

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.

Market cap (index weight) leaders:

• Technology: 16%
• Consumer Staples: 14.2%
• Financials: 13.6% (used to have largest share)

Net Income leaders (based on 2008 earnings):

• Energy: 21.6%
• Technology: 14.8%
• Financial: 9.3% (was 21.8% in 2007)

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.

Cheapest Sectors by P/E (based on 2008 earnings):

• Energy: 6.3
• Health Care: 11.1
• Technology: 12.4

While earnings are coming down, they are not coming down anywhere near as fast as prices are. As a result, the S&P is trading at its cheapest valuations in recent memory. The S&P 500 as a whole is trading for 10.9x 2008 and 8.9x 2009 earnings, respectively. Based on a blend of 33% 2008 earnings and 67% 2009 earnings; this translates to a 10.45% earnings yield, which looks extremely cheap relative to a 3.84% 10-year T-note. Even against the A-rated 10-year corporate bond yield of 7.24% it looks like a steal. 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 treasuries. Relative to treasuries, stocks have probably never been this cheap in history, with the possible exceptions of the early 1930s. It appears that the flight to quality has caused a massive bubble in the price of T-notes (and an insane bubble in the price of short term T-bills where rates approach zero, talk about being more interested in the return of capital rather than a return on capital). This is far and away, in my opinion, the most significant bubble in the market today, not the price of oil. 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.

Earnings Shares and P/Es
Sector	2007 Growth	2008 Proj. Growth	2009 Proj. Growth	Market Cap Proj. Growth	P/E FY08	P/E FY09
Technology	12.62%	14.82%	14.19%	16.86%	12.38	10.61
Cons Staple	9.82%	11.31%	10.14%	14.19%	13.64	12.49
Financials	21.78%	9.27%	16.35%	13.57%	15.92	7.41
Health Care	11.79%	13.24%	11.97%	13.48%	11.07	10.05
Energy	15.51%	21.56%	19.48%	12.42%	6.26	5.69
Industrials	11.11%	12.03%	10.81%	10.94%	9.89	9.03
Cons Discr	6.92%	6.06%	6.82%	8.61%	15.43	11.26
Utilities	3.34%	3.66%	3.30%	3.58%	10.63	9.69
Materials	3.54%	3.95%	3.68%	3.33%	9.17	8.08
Telecom	3.59%	4.11%	3.26%	3.03%	8.01	8.3
S&P 500	100.00%	100.00%	100.00%	100.00%	10.87	8.93

Additional Notes

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).

Share repurchases were still very significant in the fourth quarter of last year and the first quarter of this year (the data is not out yet for the second quarter) and the reduction in share count also boosts EPS growth.

Currency translation gains will be less of a factor this quarter due to the rebound in the dollar. However, the strong overseas demand that the previously very weak dollar stimulated will still prove to be a boost to the earnings of many firms. The delay is because in the third quarter they will be shipping goods ordered previously. Given both the rebound in the dollar and the very significant economic slowdown abroad, look for the export boom to fade in the fourth quarter and into 2009.

Regarding the bailout plan, the government will be purchase the bad investments held by the Banks and Investment banks. If the government buys at the prices this paper is currently trading for (to the extent it does trade), then it will do nothing to really solve the problem. The banks will recognize their losses which will deplete their capital, and they will report truly horrific losses. However, to the extent that it buys up the paper at above market prices, (the held to maturity value, that Bernanke is talking about, which is nothing but mark to model prices with some new model the government comes up with. Mark to model, or mark to myth, pricing was a big part of how we got into this mess) it is nothing less that a pure give away to the sector.

Neil Malkin contributed significantly to this report.

Data in this report, unless stated otherwise, is through the close on Thursday 10/2/2008

Read the full analyst report on COG

Read the full analyst report on XOM