Future Growth Called Into Question

Keep your focus on the trends in estimate revisions, not on the actual projections.

An estimate in motion tends to stay in motion. Estimates are collapsing, and nearly across the board. This means that the currently measured expectations for the fourth quarter and for 2009 are far too high. The growth rate expected for 2009 has been sustained by the expectations for 2008 dropping at a similar rate.

Versus the stable base of 2007 earnings the expected growth rate has declined to 11.9% to 12.4% just two days ago, and from 22.3% growth at the start of the month. It is my personal expectation that that number will fall below 0.0% by Christmas.

Similarly, due to a very weak fourth-quarter in 2007, year over year growth in total net income is now expected to be 17.7%, but this is down from 19.2% just last week. The fact that the revisions ratios for 2008 are deeply in negative territory in the face of more positive than negative surprises is a very negative development.

Scorecard and Median EPS Growth Rates

• 349 or 69.8% of S&P Companies have reported through Oct 30 close
• Surprise ratio at 1.96, median surprise at 2.04%, both somewhat below normal
• Median EPS growth at 6.96%, surprisingly good given the economic environment
• Energy (28 firms, up 46.6%), Industrials (45 firms, up 12.5%) and Tech (52 firms, 12.5%) leading so far
• Financials (62 firms, down 42.1%) doing the worst
• Expected Growth of 8.3% for those left to report
• Health Care leading on positive surprise front, Financials and Telecom have been disappointing

Positives:

Mylan (MYL - Analyst Report) reported EPS of 23 cents versus expectations of 12 cents. EPS was 31 cents a year ago.

Questar (STR - Analyst Report) reported EPS of 95 cents versus expectations of 78 cents. Year prior EPS was 62 cents.

Southwestern Energy (SWN - Snapshot Report) reported EPS of 53 cents versus expectations of 41 cents. EPS was 15 cents last year.

Exxon Mobil (XOM - Analyst Report) reported EPS of $2.59 versus expectations of $2.41. Profits totaled $1.70 a year prior.

Negatives:

Apache (APA - Analyst Report) reported EPS of $3.52 versus expectations of $3.98. Profits were $2.17 a year ago.

Avon Products (AVP - Analyst Report) reported EPS of 43 cents versus expectations of 51 cents. A year ago, EPS was 32 cents.

Sun Microsystems (JAVA - Snapshot Report) reported a loss of 15 cents per share versus an expected loss of 12 cents. A year ago, the company had positive earnings of 20 cents per share.

Prudential (PRU - Snapshot Report) reported EPS of 74 cents versus expectations of $1.04. EPS was $1.94 for the same quarter last year.

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).

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, these companies 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.

Total Net Income Growth

• Total net income of those that have reported down 12.8% from last year
• Total reported net income so far $137.7 billion versus $157.9 billion for same firms last year
• Those firms earned $147.2 billion in the second quarter
• Results exclude non-recurring items, most of which have been negative
• Combining results with expectations, earnings now expected to be down 12.9% year over year, which seems very optimistic
• Financials down 98.7% so far, a decline of 100.2% expected when all is said and done
• Excluding Financials, earnings are up 12.3% so far, but excluding Energy are down 22.8%
• Excluding both Energy and Financials earnings are up 4.3%
• Five sectors expected to post lower total earnings than a year ago
• Energy is the only sector expected to post robust growth, up 53.1%, Staples next best up 8.3%
• Tech and Consumer Discretionary doing well in early results, but expected to fade
• Expectations for fourth quarter net income drop to up 17.0% from 17.7% on Tuesday, and 19.2% a week ago, still looks very optimistic to me.
• Full year net income in 2009 expected to be 11.9% above 2007 levels. Count me as extremely skeptical, I think earnings in 2009 will likely be lower than in 2008

The Zacks Revisions Ratio: 2008

• Revisions ratio for full S&P 500 up to 0.28, from 0.27 on Tuesday
• Health Care by far the strongest at 1.08 in response to earnings surprises.
• Health Care accounts for 26% of all estimate increases; excluding health care, revisions ratio falls to 0.22
• Cuts outnumber increases by more than 3:1 in 8 of 10 sectors
• Ratio of firms with rising to falling mean estimates at 0.24, up from 0.23
• Total number of revisions (4 week total) up to 3,474 from 3,274 on Tuesday
• Increases up to 763 from 695, cuts up to 2,711 from 2,579

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 Zacks Revisions Ratio: 2009

• Full S&P 500 2009 revisions ratio up to 0.13 from 0.12 on Thursday
• Over 1 in 5 S&P firms see mean estimate for 2009 fall by more than 15%
• More than 6 cuts per increase for 9 sectors
• Health Care the "best" at a 0.47 reading
• Ratio of rising to falling mean estimates steady at 0.13
• Total number of revisions up to 3,437 from 2,239 on Tuesday
• Increases up to 378 from 362, cuts up to 3,059 from 2,877
• Only thing holding up 2009 expected growth is the decline of 2008 base

Market Cap versus Total Earnings

• S&P 500 down to 12.0x 2008, and 10.1x 2009 currently expected earnings
• Forward Earnings Yield of 9.44% wildly attractive relative to 10 year T-note of 3.94%
• Real P/Es are higher (and earnings yields lower) since the “E” is still way too high
• Financials expected to get 6.5% of total S&P earnings in 2008, down from 21.6% in 2007; sector could rebound to 15.7% expected for 2009. Financials currently represent 13.8% of total market cap
• Energy’s share expected to grow to 22.3% of total in 2008 from 15.6% in 2007, but the sector is expected to recede to 18.8% in 2009.
• Energy represents just 12.8% of the index market cap
• All sectors but Financials and Consumer Discretionary expected to lose earnings share in 2009. Both Financials and Consumer Discretionary will be below 2007 shares
• Energy P/E by far the lowest for both 2008 and 2009, at 6.9x and 6.9x, respectively

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 P/E’s are calculated as the total Market Capitalization of the sector divided by the total expected earnings for the sector.

Neil Malkin contributed significantly to this report.

Data in this report, unless stated otherwise, is through the close on Thursday 10/30/2008