Positive Surprises Not Helping 2009 Forecasts

Highlighted stocks include Bank of America Corporation (BAC - Analyst Report), Exxon Mobil Corporation (XOM - Analyst Report), PNC Financial Services (PNC - Snapshot Report) and Wells Fargo & Company (WFC - Analyst Report).

Key Points:

• There are more positive surprises than disappointments, but by a below normal margin
• Fourth-quarter reports for S&P 500 (SPX) members are ugly (273 total) with total net income 39.6% below a year ago
• Excluding Financials, total earnings down 22.3% so far
• Fourth-quarter total net income expected to be 31.1% below year ago levels
• Positive surprises are not translating into 2009 estimate increases
• 2009 cuts still outnumbering increases by more than 5:1, but the rate of decline is slowing
• Total net income in 2009 now expected to fall 8.4%, following 13.2% 2008 decline
• P/Es based on 2009 estimates will prove to be to low as "E" plunges
• Bottom up estimate for S&P 500 now $66.34 in 2009, down from $66.60 on Thursday and $69.04 a week ago., I expect it to be significantly less than $60.

Total Net Income Growth

We are now more than halfway done with earnings season and it has been the toughest in recent memory.

Total net income of the 273 S&P 500 firms that have already reported is $76.2 billion. This is 39.6% below the $126.0 billion that those same companies reported a year ago, and is 45.3% below what they reported in the third quarter. Thus, anyway you slice it, it’s ugly. Not surprisingly the worst damage has been in the Financial sector, which is collectively drowning in $18.4 billion of red ink versus a collective profit of $4.3 billion a year ago.

Keep in mind that these figures are based on the S&P 500 as it is currently constituted. This greatly understates the financial sector losses. For example Merrill Lynch reported over $15 billion in losses in the fourth quarter, but it dropped out of the index when it was absorbed by Bank of America Corporation (BAC - Analyst Report) at the beginning of January. The losses do not show up on the BAC line, and Merrill is no longer in the index. The story is the same for Wells Fargo & Company (WFC - Analyst Report) and Wachovia, as well as for PNC Financial Services (PNC - Snapshot Report) and National City. In short, as bad as the Financial sectors numbers look, the reality is much worse.

Even if we back out the ongoing disaster that is the Financial sector, things still look ugly.

Excluding financials, total net income is down 22.3% so far. The damage is widespread, with every sector except for Health Care and Utilities reporting lower total net income than a year ago. Health Care is famously defensive and relatively insensitive to the economy. Utilities are being helped by fuel cost falling faster than electrical rates, many of which were increased last spring in response to the rapid rise in fuel costs back then.

There is some hope for improvement. Analysts expect the damage at the late reporting firms to be less than the damage from those that have already reported. Collectively the late reporters are expected to see total net income fall by just 8.4%. If we combine the expectations for those yet to report with the actual results already posted the expectation is for total net income to decline by 31.1% in the fourth quarter.

Total Net Income Growth (Reported)
Sector	Q2 '08 A	Q3 '08 A	Q4 '08 A	Q1 '09 E	2007 A	2008 A	2009 E	2010 E
Health Care	8.76%	6.65%	8.85%	-3.46%	19.89%	9.04%	0.28%	11.47%
Utilities	5.10%	-4.17%	7.28%	-0.12%	16.08%	5.53%	3.41%	8.07%
Telecom	7.13%	-5.74%	-9.85%	-25.80%	25.47%	3.24%	-14.11%	6.17%
Cons. Stap.	-11.70%	-5.88%	-19.34%	-8.87%	3.87%	-10.90%	11.60%	2.73%
Industrials	5.57%	0.13%	-21.23%	-31.58%	10.08%	0.54%	-17.80%	9.26%
Technology	21.39%	10.81%	-24.62%	-35.33%	10.50%	15.04%	-16.53%	21.54%
Energy	12.57%	54.22%	-25.65%	-53.27%	8.93%	17.44%	-43.40%	32.35%
Materials	5.44%	5.71%	-86.91%	-63.29%	12.51%	-10.31%	-41.32%	37.16%
Cons. Disc.	-36.49%	-46.54%	-89.06%	-68.42%	-0.33%	-42.15%	4.20%	79.85%
Financials	-52.03%	-65.95%	-529.69%	-49.21%	-20.10%	-77.56%	79.71%	77.50%
S&P	-8.22%	-5.58%	-39.57%	-34.90%	2.80%	-12.64%	-13.40%	25.39%

Total Net Income (Reported)
Sector	Q4 '08	Q4 '07	Q3 '08	Q3 '07
Health Care	$21,414	$19,672	$21,659	$20,308
Energy	$21,173	$28,478	$38,199	$24,769
Technology	$17,516	$23,238	$19,965	$18,018
Industrials	$17,396	$22,086	$20,346	$20,320
Cons. Stap.	$7,479	$9,273	$8,556	$9,091
Telecom	$5,525	$6,129	$5,802	$6,155
Utilities	$2,860	$2,666	$4,522	$4,718
Materials	$634	$4,840	$5,810	$5,496
Cons. Disc.	$586	$5,357	$3,501	$6,549
Financials	($18,422)	$4,287	$10,926	$32,088
S&P	$76,161	$126,025	$139,285	$147,512

Total Net Income Growth (Not Reported)
Sector	Q2 '08 A	Q3 '08 A	Q4 '08 E	Q1 '09 E	2007 A	2008 E	2009 E	2010 E
Financials	-60.08%	-161.70%	147.29%	295.61%	-9.24%	-81.95%	242.16%	8.33%
Cons. Stap.	12.31%	30.30%	16.02%	9.75%	10.10%	31.06%	4.48%	9.89%
Utilities	3.17%	-7.89%	13.54%	-14.04%	5.81%	1.66%	3.26%	13.74%
Health Care	9.21%	9.09%	7.91%	6.65%	17.22%	9.09%	8.44%	13.59%
Industrials	11.38%	8.83%	-0.64%	14.26%	10.02%	11.90%	-7.39%	2.17%
Technology	8.48%	-0.97%	-18.63%	-22.90%	14.83%	12.90%	-8.21%	14.22%
Energy	35.99%	68.12%	-28.12%	-34.87%	10.01%	30.26%	-32.47%	28.64%
Materials	11.76%	-16.04%	-52.09%	-24.45%	-3.08%	-3.34%	-15.12%	29.96%
Cons. Disc.	-73.09%	-41.48%	-55.04%	-46.63%	1.92%	-56.37%	9.19%	91.95%
Telecom	-36.95%	-59.17%	-61.63%	-36.43%	-6.07%	-44.95%	-23.98%	-9.33%
S&P	-18.23%	-27.60%	-8.39%	-6.86%	4.49%	-14.60%	5.41%	20.17%

Total Net Income Growth (Combined)
Sector	Q2 '08 A	Q3 '08 A	Q4 '08 E	Q1 '09 E	2007 A	2008 E	2009 E	2010 E
Utilities	4.11%	-5.99%	10.66%	-7.23%	10.62%	3.56%	3.33%	10.90%
Health Care	8.84%	7.07%	8.69%	-1.76%	19.43%	9.05%	1.64%	11.85%
Cons. Stap.	2.04%	13.45%	-1.06%	2.94%	7.23%	12.33%	7.00%	7.25%
Telecom	-1.11%	-15.97%	-19.03%	-26.98%	18.24%	-5.54%	-15.16%	4.70%
Industrials	6.23%	1.08%	-19.38%	-26.93%	10.07%	1.68%	-16.65%	8.39%
Technology	17.37%	7.46%	-23.10%	-31.55%	11.69%	14.43%	-14.21%	19.36%
Energy	16.25%	56.44%	-26.06%	-49.92%	9.11%	19.58%	-41.41%	31.57%
Cons. Disc.	-58.72%	-43.68%	-67.41%	-53.20%	1.07%	-51.07%	7.00%	86.76%
Materials	6.18%	2.03%	-80.80%	-58.60%	10.15%	-9.38%	-37.61%	35.77%
Financials	-53.87%	-89.80%	-296.28%	-20.04%	-17.67%	-78.64%	113.52%	54.44%
S&P	-10.95%	-11.57%	-31.09%	-27.11%	3.26%	-13.18%	-8.36%	23.78%

Scorecard and Median EPS Growth Rates

Despite the abysmal figures on total net income, there have actually been more companies reporting positive surprises than earnings disappointments. The median surprise is 1.96% and the ratio of positive surprises to disappointments stands at 1.6:1. While that is good news, over the last 5 years, the normal level for these measures has been a median surprise of more than 3.0% and a surprise ratio of 3:1 or better. Managements learned a while ago that it is better to "under promise and over perform" than vice versa, and thus have a tendency to keep their guidance conservative.

The Health Care sector has been surprisingly good, with positive surprises outnumbering disappointments by almost a 7:1 ratio, although the median surprise in the sector is only a so-so 2.44%. Energy and Materials both have much bigger median surprises, but a much lower relative frequency of positive surprises. Energy is also showing positive growth in EPS, despite plunging total net income (medians are inherently equally weighted, while total net income can be dominated by a few huge firms like Exxon Mobil Corporation (XOM - Analyst Report)) .

Materials is a disaster on both fronts. However, if the expectations are set low enough, even an absolute disaster can be a relative positive surprise (YEA, they are not bankrupt yet).

Looking forward to the first quarter and all of 2009, the picture for those firms that have already reported is much bleaker for the first quarter, with median EPS expected to fall 19.5%, than it is among those who have not reported yet (-3.5%). While there is some difference in the industry make up of the two groups, I doubt that is the reason for the huge difference. More likely is the negative guidance being given by management when they report their fourth quarter earnings. I would expect the first quarter expectations for the yet to report group to plunge as soon as they do report. The overall decline for 2009 is currently expected to be 6.9% on a median EPS growth basis and -8.4% on a total net income basis.

However this is just a still from a moving picture, and the direction is very much still down. Thus it seems highly likely that the actual earnings declines will be far steeper than the current expectations now reflect. Translated into a bottom up estimate for the S&P 500, the index is currently expected to "earn" $66.34 in 2009, down from $74.40 in 2008. This strikes me as extremely optimistic, just a week ago it was expected to earn $69.04. If one extends the recent trends, it seems more likely that the 2009 earnings will come in closer to $55. Considering the state of the economy, even that figure might prove optimistic.

The big question then is what sort of multiple should be put on those earnings. Usually low inflation and low interest rates argue for relatively high P/E multiples, and these are "depressed" earnings. However we do not have much experience with what sort of multiples stocks trade at when we actually have deflation, and interest rates have started to climb sharply off the absurdly low levels they were at (at least for Treasuries) at the beginning of the year. A 12x multiple on earnings of $55 would put the market at 660, a 21.3% drop from its current 838.51 level. If you buy the premise that earnings will be $55 for 2009, one has to think that the "fair multiple" for the S&P 500 on 2009 earnings is higher than 15x.

Fourth-Quarter Scorecard (Reported)
Sector	4Q '08 (A)	1Q '09 (E)	2008 (A)	2009 (E)	2010 (E)	% Reported	Median % Surprise	# Pos Surprise	# Neg Surprise	# Match
Healthcare	11.12%	6.78%	16.19%	6.56%	10.62%	55.56%	2.44%	20	3	7
Energy	7.07%	-25.62%	19.15%	-36.26%	9.69%	48.72%	6.71%	12	6	1
Utilities	4.90%	-3.21%	6.69%	4.60%	8.36%	32.35%	1.90%	6	4	1
Industrial	-0.16%	-21.32%	13.32%	-12.40%	9.26%	71.19%	2.04%	25	8	9
Telecom	-5.74%	-17.86%	4.54%	-9.92%	5.50%	22.22%	-2.32%	0	2	0
Cons. Stap.	-6.04%	-2.60%	10.67%	4.05%	7.97%	40.00%	1.86%	10	5	1
Tech	-13.03%	-33.33%	13.56%	-17.50%	9.93%	64.00%	3.10%	28	16	4
Cons. Disc.	-31.48%	-19.72%	-9.63%	-13.73%	9.19%	45.00%	4.09%	23	11	2
Financial	-34.21%	-45.45%	-21.79%	-6.18%	13.73%	60.49%	-12.50%	14	31	4
Materials	-60.13%	-64.14%	-6.95%	-26.23%	15.19%	68.97%	5.83%	12	7	1
S&P 500	-8.57%	-19.48%	6.92%	-6.85%	10.51%	54.60%	1.96%	150	93	30

Fourth-Quarter EPS Growth (Yet-to-Report)
Sector	4Q '08 Growth (E)	1Q '09 Growth (E)	2008 Growth (E)	2009 Growth (E)
Healthcare	5.69%	5.39%	13.89%	17.60%
Cons. Stap.	3.95%	0.90%	9.69%	11.30%
Industrial	0.00%	-3.03%	10.87%	15.29%
Utilities	0.00%	6.25%	0.00%	9.09%
Telecom	-2.47%	-8.70%	74.21%	-2.94%
Financial	-11.51%	-7.81%	11.52%	10.62%
Energy	-15.47%	-30.96%	19.44%	13.31%
Tech	-23.68%	2.63%	16.99%	22.98%
Cons. Disc.	-24.39%	-20.02%	15.03%	9.41%
Materials	-41.76%	-24.39%	18.10%	7.38%
S&P 500	-5.52%	-3.50%	11.72%	13.23%

The Zacks Revisions Ratio: 2009

• Revisions ratio for full S&P 500 down to 0.18, from 0.19 on Thursday
• Health Care the "strongest" as positive surprises help it
• 9 sectors have at least 3 cuts for every increase, 3 have more than 10 per increase
• 32.0% of all firms see mean estimate decline by more than 10%, 19.6% more than 20%
• Ratio of firms with rising to falling mean estimates down to 0.16 from 0.18 on Thursday
• Total number of revisions (4-week total) up to 3,329 from 2,656 on Thursday (25.3%)
• Increases up to 507 from 410 (23.6%), cuts up to 2,822 from 2,216 (27.3%)
• Estimate activity picking up sharply, with a few weeks of peak

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.

SECTOR	Avg. 4wk Change FY1	Revisions Ratio: #ests up/# ests dn 4 wk	# Of Firms with FY1 EPS 4wk Increase	# Of Firms with FY1 EPS 4wk Decrease
Health Care	-2.69%	0.51	18	36
Consumer Staple	-3.74%	0.29	12	27
Technology	-11.25%	0.26	10	61
Consumer Disc	-9.46%	0.17	7	71
Utilities	-2.68%	0.14	4	30
Energy	-17.89%	0.14	2	37
Materials	-19.21%	0.11	2	27
Financial Services	-12.20%	0.09	7	73
Industrials	-10.24%	0.06	4	51
Telecom	-6.20%	0.06	1	8
S&P 500	-9.69%	0.18	67	421

Neil Malkin contributed significantly to this report.

Data in this report, unless stated otherwise, is through the close on Tuesday, Feb 3, 2009