Second quarter earnings are likely to produce gains generally consistent with first quarter earnings growth. That should be sufficient to support current stock prices, barring any major exogenous event in Europe.
How the Game Works
Earnings estimates from Wall Street analysts typically follow a similar pattern every quarter.
Several quarters out, and even in the months prior to any quarter, analysts are optimistic. That is their nature with regard to the companies they follow. Management presents how they are going to grow earnings, and analysts generally buy into the plan.
Then, as any individual quarter approaches, earnings estimates start coming down. This is in part simply a return to reality, but also involves companies presenting a cautious near-term outlook. Companies don’t want to over promise and under produce. Analysts start to cut estimates.
For the first quarter of this year, for example, earnings estimates in December for the S&P 500 in aggregate were for a 6% earnings gain. Then, earnings estimates came down steadily to as low as 2% during the quarter.
The bar had been lowered. That benefits the companies, and the analysts. No one benefits from a company reporting earnings below estimates.
As the reports started coming out, most companies beat estimates. This always happens. At least 60% of the companies beat estimates, and the aggregate earnings gain starts coming in ahead of expectations.
First quarter earnings estimates were particularly high relative to estimates, and the final earnings gain for the S&P 500 was 8%. This was well above the 2% to 3% expected ahead of earnings reports, and even above the 6% forecast at the start of the quarter.
Normally, the final earnings gain comes in about 3% higher than the forecast as of the start of the reports.
Second Quarter Forecast Trends
For the second quarter, earnings estimates, as is typical in the months ahead of the quarter, have been coming down.
At the start of this year, forecasts had been at 10% or higher for the increase for second quarter earnings for the S&P 500 in aggregate.
They have now come down to 8%.
Earnings reports do not start until the second week of July and it would not be surprising to see the aggregate estimate drop to as low as 6%. The weeks ahead of reports typically bring some earnings warnings from companies (so as not to disappoint with the actual report). Global economic growth is slowing, and analyst could get cautious and lower company estimates.
Then, of course, reports will start coming in ahead of expectations. If the final prognostication is near 6%, it would not be at all surprising to see second quarter earnings finish near 9% growth over the second quarter of last year.
A 9% earnings gain in the second quarter, following the 8% earnings gain in the first quarter, is more than enough to support current stock valuations.
S&P 500 earnings rose 14% in 2011. The S&P 500 index was flat. The market underperformed relative to the earnings gain.
S&P 500 earnings are on track to be up about 8% to 9% in the first half of this year. To date, the S&P 500 has risen about 6%. That translates into roughly a 12% annual rate of increase (to compare with the year-over-year earnings gains). The S&P 500 is slightly outperforming earnings this year. The outperformance this year, however, does not make up for the underperformance las year.
The price/earnings ratio on the S&P 500 using the past four quarter earnings is approximately 13. That is a 7.7% earnings yield.
The price/earnings ratio on the S&P 500 using the expected next four quarter earnings is approximately 12. That is an 8.3% earnings yield.
Those earnings yields are outstanding relative to alternative available yields and are high from a historical perspective. Stocks have excellent value.
The earnings analysis is not all positive.
One concern is that the second quarter earnings gain will not be broad. In fact, the total earnings gain is largely a result of a huge jump in earnings for Bank of America.
In the second quarter of 2011, Bank of America reported a huge loss. This year, the absence of that huge loss results in a large improvement in earnings.
Excluding Bank of America, current forecasts are for the S&P 500 earnings to rise just 1%. That means that most companies are struggling to increase earnings.
Of course, a current 1% forecast suggests as much as an ultimate 4% increase in earnings for the S&P 500 excluding Bank of America, but that still isn’t particularly impressive. So, there will be widespread concern that a lot of companies are treading water.
In addition, the outlook for earnings growth is highly uncertain.
There are understandable concerns about the stagnant economies across Europe. China is slowing down. It is also apparent that US growth is slowing.
Real GDP Forecast and Cautious Guidance
Our forecast for second quarter real GDP growth stands at a measly 1.4% annual rate.
First quarter growth was 1.9% but since then employment growth, retail sales, industrial production, and a number of other key economic series have increased at a slower pace.
The US economic slowdown and the extreme anxiety over the outlook in Europe is likely to lead many companies to present a very cautious outlook for earnings for the second half of 2012.
Many of the S&P 500 companies are likely to report modest earnings gains coupled with cautious guidance.
What It All Means
The market’s obsession with all things Europe will moderate in the weeks ahead. Second quarter earnings will start becoming a focal point.
During the next two weeks, the focus is likely to be on any companies issuing earnings warnings and any lowering of earnings forecasts. Caution will dominate sentiment. In the comparable period in late March and early April, the S&P 500 index sagged.
As the reports start coming out, there will be some of the typical relief when the majority of companies report earnings estimates ahead of expectations. By the end of April, as first quarter earnings reports were wrapping up, the S&P 500 had experienced a brief relief rally. A similar relief rally in late July is possible with second quarter earnings.
The overall earnings trends are good enough to justify current stock prices. Earnings have been rising through 2011 and 2012 at a decent clip and stock gains haven’t kept up.
There will be a great deal of talk, however, about earnings excluding Bank of America. That will take steam out of the optimism associated with the overall earnings growth.
There will also be legitimate concerns that the slowdown in global economic growth will lead to a substantial reduction in earnings growth in the second half of the year, perhaps to low single digits.
Second quarter earnings reports will be good but not great. They may provide support to the market (barring a major event in Europe). But they also aren’t going to prompt a sustained rally heading out of July into what is likely to be continued choppy conditions through the remainder of the summer months.
Founder and Chairman, Briefing.com