For the baseball fans among us, the last game of the World Series marks the true change of seasons. And change is certainly likely over the next two weeks. Today is Election Day in the U.S. and by all accounts the balance of power in Washington is likely to change significantly. After the ballots are counted, even more change is a foot as the Fed meets to consider “QE2” and the world’s other central bankers in Europe and Japan contemplate possibly similar moves of quantitative easing. This article is the first in a series of two: first we look at the latest economic indicators and corporate earnings and next week we’ll comment on the market implications of the U.S. elections and central bank actions.
Real GDP expanded 2.0 percent in 2010:Q3, representing just a modest improvement from the 1.7 percent pace registered in 2010:Q2. Despite the tempered headline real GDP print, the data shows that the U.S. economy is improving from the “soft patch” earlier in 2010:Q2. Real consumption spending rose 2.6 percent in 2010:Q3, its strongest reading in nearly four years. This acceleration in personal consumption limited the net rise in inventories to just $46.7 billion, suggesting that corporate America will still need to increase production and inventory positions over the next several months, boding well for continued, albeit measured growth in the fourth quarter and into next year.
The most interesting aspect about the economy last quarter was that corporations, as witnessed by the latest earnings and sales data, did better than the economy: more than 80 percent of the S&P 500 companies have exceeded their profit estimates. The continued strength in corporate earnings and the need to replenish inventory positions, combined with the upcoming monetary and fiscal policy actions, is likely to provide support to the economy. The net result raises the likelihood that the U.S. economy will continue its path to recovery and avoid a double dip recession.
After very strong earnings performance during the first half of 2010, expectations for corporate profits during the second half of the year were muted. Going into the third quarter, expectations were for S&P 500 earnings to grow by 24 percent as a whole, a sequential decline from the previous periods. But once again, actual results have come in substantially better. As of October 28th, 270 companies, or 54 percent of the S&P 500 Index, have reported results and as a group, have delivered earnings growth of over 41 percent, well of ahead of the consensus view. In fact, of those reporting, 82 percent have surpassed earnings expectations marking the sixth consecutive quarter of earnings surprises above 75 percent versus a long-term historical average of about 60 percent.
The degree to which companies are outpacing expectations continues to be extremely high as well, with those reporting companies beating expectations by over 8.5 percent compared to the historical average of just 3.5 percent. The diversity of the growth continues to broaden too with almost 81 percent of companies in the S&P 500 experiencing positive growth in earnings. Further, all ten sectors are experiencing positive earnings surprises ranging from less than one percent in telecommunications to almost 20 percent in financials.
The trends in revenue growth this quarter continue to confirm that growth is resulting from demand in the economy rather than cost reductions. Over 61 percent of S&P 500 companies have reported positive revenue surprises. As was the case for earnings, expectations for revenue growth were somewhat lower this quarter after the double digit rates of growth seen in the first half, but the sales growth rate has remained high with the aggregate number over 9 percent, a significant margin above the 7 percent expected.
With the threat of a softening economy still lingering in investors’ minds, the guidance provided by company management this reporting season is keenly viewed as a signpost of what’s to come. And indications have been encouraging. As of October 27th, roughly 30 percent of companies that have reported provided upside guidance, and unlike the previous quarter when the technology sector dominated the upward guidance, this quarter has seen guidance moving up across sectors, and revisions have followed. For 2010, the positive revision ratio for the S&P 500 stands at 1.85, or almost two estimates revised up for every one moving down. The trend is positive for 2011 as well with ratio now at 1.22.
Third quarter earnings have served as a calming influence in an uncertain market environment and in fact, have become a catalyst for a further move higher. Going forward, strong earnings could continue to provide support for the economic recovery during a period when the S&P 500 Index is reasonably priced at 14 times 2010’s estimated earnings of roughly $85 and 12.5 times 2011’s estimated earnings of close to $95.
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