- As has been the case for much of the last year and a half, strong corporate earnings have been largely overshadowed by macro concerns related to both the U.S. economy and the state of affairs globally.
- Even with year-over-year comparisons becoming more challenging for many companies and growth expectations at elevated levels, fourth quarter 2010 earnings have continued to deliver positive upside surprises.
- At this point in the reporting season, this quarter would mark the seventh consecutive quarter of earnings surprises above 70 percent, and perhaps more surprisingly, the sixth quarter of revenue surprises above 60 percent.
- When looked at from a historical perspective, this earnings recovery has been a powerful one.
While analyzing fourth quarter earnings at this time last year, we wrote that “…stronger than expected results have gone largely unnoticed as politics have dominated the investment landscape.” That comment certainly remained true during the fourth quarter of 2010, but with the November elections playing out as expected, the opacity of potential government regulation was removed and investor attention shifted to economic data which increasingly pointed to a stronger and improving environment. It was these indicators, and not corporate fundamentals, that provided a green light to investors who took the S&P 500 almost 11 percent higher during the December quarter and another five percent higher in the New Year even in the face of growing unrest in the Middle East.
2010 was undoubtedly a very strong year for earnings growth with an annual increase of 47 percent. However, some viewed the anticipated 28 percent earnings in the fourth quarter as overly optimistic given that the first nine months of the year had already been very strong and the fourth quarter of 2009 had experienced growth of 65 percent, so year-over-year comparisons could prove more difficult. Despite these concerns, actual results have once again come in substantially better than equity analysts had forecasted. The 337 companies in the S&P 500 Index that reported as of February 10 have delivered earnings growth of over 37 percent, well ahead of the consensus view.
In addition to the strong absolute level of growth in earnings, the overwhelming majority of companies have been exceeding expectations by a wide margin. Three out of four companies have reported a positive earnings surprise and the magnitude of these surprises was historically high at 7 percent, two times the long-term average. It is important to note that the gains are broad-based across many sectors of the economy with 77 percent of companies reporting earnings growth in the fourth quarter.
And looking forward, the earnings landscape continues to improve. 11 percent of companies reported have guided their 2011 earnings higher and analysts have behaved accordingly by moving the consensus estimates higher. The revisions ratio for 2011 now stands at 1.88, or essentially, two companies’ estimates are being revised higher for every one revised lower and the same is true for 2012 where the revision ratio is now at 1.83.
Importantly, with the U.S. economy now moving from recovery to expansion, earnings growth takes a back seat to revenue growth in the minds of many investors since sales growth is required to maintain current business levels and eventually fuel further investment which, in turn, leads to job creation. Revenue results have not disappointed in this regard: with market expectations of 5.5 percent growth for the quarter, actual revenues of those reporting have grown by 8.6 percent. Additionally, 71 percent of companies have surprised to the upside, a level that is higher than the already strong period of the previous four quarters. Overall, 78 percent of companies are experiencing positive revenue growth.
Real GDP growth increased 3.2 percent in 2010:Q4, a bit below our 3.5 - 4.0 percent forecast, but stronger than the 2.6 percent advance posted in 2010:Q3. However, the tempered headline real GDP print was solely due to a sharper-than-expected drop in inventories which subtracted 3.7 percentage points from real GDP in the final quarter last year, versus estimates of a 2.5 percentage point drag. This big hit to inventories was the largest drawdown in almost 23 years, but it will likely be partially reversed in subsequent updates and should also provide a catalyst to strong rebuilding of depleted inventory positions, and thus GDP growth, in 2011. Several key demand-side components of the real GDP report revealed significant strength in 2010:Q4 that helped to fuel the better revenue and earnings results for the quarter. Real consumption spending surged 4.4 percent (the strongest since 2006:Q1), while exports increased 8.5 percent. The gains in these two components were key catalysts to a 7.1 percent rise in real final sales (one of its biggest increases in this component over the last 25+ years), which further validated the robust private-sector activity late last year.
At this point in the U.S. economic cycle, it is clear that earnings have rebounded substantially and we now have enough data to assess how this earnings recovery compares to the two most recent recessions. What we can conclude is that the earnings recovery has proved to be much more powerful than what was experienced in the recent past, reflecting several hidden benefits associated with a reduction in unit labor costs a surge in productivity, improved manufacturing efficiency, and a strong export market.
Based on the rolling 12-month operating earnings of the S&P 500, the peak occurred in June of 2007 when S&P earnings were over $91. By the third quarter of 2009, the rolling earnings per share had fallen almost 57 percent to roughly $39. Using the estimated 12-month December 2010 number of almost $84, earnings have bounced back by over 111 percent.
In comparison, for the recessions of 2001 and 1991, earnings had only recovered 22 percent and 15 percent, respectively. The consensus 2011 earnings estimate from S&P now stands at $96 which would put nine quarter recovery at roughly 142 percent – an all time high levels. Again comparing this to 2001 and 1991, the nine-quarter recoveries were up 49 percent and 44 percent, respectively.
Chart 1 | S&P 500 Rolling Four Quarter Operating Earnings
In conclusion, fourth quarter earnings have once again surpassed expectations, providing further support that the operating fundamentals at U.S. corporations are sound enough to support increased growth going forward. With net profit margins at all time highs and earnings revisions continuing to move higher, it is not unreasonable that 3.5 to 4.0 percent real GDP growth and 2011 earnings of $96 could be achieved and perhaps exceeded. Even with the strong move up seen in the fourth quarter, $96 in earnings would leave the S&P 500 trading at a historically fair price to earnings valuation of 13.6 times. And if the earnings number were to actually come in closer to $100 (4 percent higher than market consensus expectations) and the S&P 500 were to finish the year at our 1400 to 1450 target (roughly 6 to 10 percent higher from today), the valuation would still be at a historically mild 14 to 14.5 times earnings.
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