by Michael Strauss, Chief Economist and Chief Investment Strategist and Jeff Boris, Director, Equities
- The S&P 500 Index is up over 8 percent in 2011 through April despite significant challenges to the macro-economic environment and increasing geopolitical instability. Market strength can again be attributed to continued strong corporate performance, as the first quarter earnings season has once again outpaced the expectations of the market as corporations continue to do better than the economy.
- We continue to retain our outlook for the S&P 500 Index to rise to 1400-1450 by year-end and we look for real GDP growth to reaccelerate at a 3 to 3.3 percent pace over the remaining three quarters in 2011, with the business side of the equation being a stronger component of the bounce back in economic activity
- However, at current levels, the S&P 500 Index market may be ahead of itself as the strength in earnings may fade and inflation risks resurface. All eyes will be on the sustainability of both earnings and revenue growth and more specifically, which sectors will be able to deliver above average growth going forward.
Despite the seemingly heavy burden of the earthquake in Japan, unrest in the Middle East and North Africa, U.S. budget issues and the poor weather that plagued much of the U.S. throughout the first quarter of the year, corporations continued to deliver strong profits, supporting our longstanding theme that companies are doing better than the economy. As a result, domestic stocks have responded positively to another round of strong results with the S&P 500 Index climbing over seven percent higher since the middle of March. In fact, unlike previous quarters in 2010, this quarter’s strong earnings season has actually served to help clarify some measure of uncertainty and provide a catalyst to take stocks higher.
With 299 companies in the S&P 500 Index reported as of April 29th, more than 77 percent of them have beaten their first quarter earnings estimate. That percentage is well ahead of the historical beat rate and ahead of the roughly 70 percent positive earnings print the market has grown accustomed to over the last several quarters. More impressive, for those companies that have reported, the earnings growth has averaged almost 23 percent, ahead of the anticipated 16 percent gain and broadly diversified across all sectors except telecommunications.
In addition to the strong absolute level of growth, the magnitude of the outperformance is historically high at 8.3 percent, significantly above the 3.5 percent long-term average and, in fact, the highest percentage above consensus since the first quarter of 2010. Again, with the exception of the energy sector which still awaits results from the large integrated companies, all sectors are experiencing positive earnings results with three sectors besting forecasts by more than 10 percent.
Real GDP growth decelerated to a 1.8 percent pace in 2011:Q1, within striking distance of market consensus estimates centered at 2 percent, but below the 3.1 percent growth rate in 2010:Q4. Most estimates at the start of the quarter were in the 3 to 4 percent area. The deceleration in economic activity in 2011:Q1 was largely fueled by a combination of temporary factors including horrible weather conditions (as witnessed by a 21.7 percent plunge in the structures component of fixed investment and the 4.1 percent decline in residential investment) and dislocations associated with events in the Middle East, North Africa, and Japan. However, the softer GDP print did not appear to hurt corporate profits.
Given where we are in the recovery cycle, the shine of robust earnings is perhaps eclipsed by strength on the revenue side of the equation. Of the S&P 500 companies reported, 76 percent have beaten estimates and the revenue strength has largely cut across all sectors. Revenue growth in aggregate has come in at 10 percent with the energy sector growing revenue by almost 30 percent and three cyclically-oriented sectors experiencing double-digit revenue growth.
Most impressive, though, is the measure of the size of the revenue outperformance which currently stands at five percentage points over expectations. We caution investors not to extrapolate this performance to all sectors quite yet, however, as many of the large retail-oriented consumer discretionary companies (which are more susceptible to near-term factors like high oil prices and poor weather and the associated challenges on the consumer discretionary spending front) will not report until May. These results may negatively impact the aggregate revenue gains. Moreover, a portion of the strength in earnings may also be a benefit of the weaker dollar and the associated stronger earnings from the repatriation of foreign profits back into the greenback at more favorable exchange rates. Notwithstanding these cautionary flags, the strength in revenues vis-à-vis market expectations is impressive, as large revenue “beats” typically occur around market turning points rather than in the middle of a cycle.
Real personal consumption spending expanded at a still solid 2.7 percent pace in 2011:Q1, reflecting continued strength in the durables sector (+10.6 percent). Despite the constraints associated with higher food and energy prices, the consumer remained the “energizer bunny”, possibly reflecting the positive benefits of the improvement in the wealth effect (higher stock prices), the better labor readings associated with the one percentage point decline in the civilian unemployment rate, and the reduction in social security taxes at the start of the year which boosted real disposable income. With gasoline prices now above the $4 per gallon area in many parts of the country and supply chain disruptions adding to already challenging inflation readings, we believe that the consumer discretionary side of the equation for large ticket durable goods will temper in the upcoming months.
Business investment in equipment and structures rose a robust 11.6 percent in 2011:Q1, receiving a benefit from the latest round of investment tax credits as well as support from the continued increase in corporate profits. This component should remain a source of strength for the balance of this year. On the trade front, goods exports rose 7.8 percent, which basically offset the 4.4 percent rise in the large goods imports component. Near term, the real trade numbers should be a source of economic growth as imports from Japan in the goods sector decline due to a variety of supply disruptions. The weaker dollar should also help boost U.S. exports of manufactured goods. Net, we look for real GDP growth to reaccelerate at a 3 to 3.3 percent pace over the remaining three quarters in 2011, with the business side of the equation being a stronger component of the bounce back in economic activity.
As the earnings season has progressed, strong results have pushed forward estimates higher. As noted in the revenue section above, the biggest beneficiaries have been the historically cyclical sectors like energy, materials and technology, but the aggregate revision numbers have been quite good as well. For the S&P 500 Index, the positive revision ratio now stands at 1.54 for 2011, or essentially, one and a half companies’ estimates are being revised higher for every one revised lower; for 2012, the number is even more compelling at 1.91.
In terms of earnings for the market as a whole, the 2011 bottom-up earnings estimate for the S&P 500 Index has now climbed to $98.65 and the 2012 estimate has been elevated to close to $110. With the S&P 500 currently trading at 1363, the valuation stands at a historically mild 13.8 times 2011 earnings and 12.4 times the 2012 number, perhaps creating the opportunity for further upside as economic conditions within the U.S. rebound from the 1.8 percent real growth pace registered in 2011:Q1. We are still maintaining our 1400 to 1450 target for the S&P 500 Index for this year, but we are a bit cautious at this juncture that the market might be a bit ahead of itself.
Despite the robust gain in revenue, earnings, and the equity market itself, caution is warranted. The budget battle in Washington is heated and we may find that the debt ceiling and the need to implement a true budget deficit-cutting action plan may both become hostages to Washington politics at its worst. Internationally, the debt challenges of the “club Med” countries have deteriorated and its looks like Greece will need a new debt restructuring plan that could fuel similar action in Portugal and Ireland. These events, combined with the continued challenges in the Middle East and North Africa, supply chain disruptions from Japan, and the ending of QE II, should provide an interesting test for the capital markets at these levels, with the greatest vulnerability centered in the long end of the Treasury market.
Another caution flag is the near term direction of the inflation readings. The price components in the latest real GDP report provide another sign that inflation pressures are building and that the Fed’s tame view on inflation will be challenged. Bernanke and company may try to hide behind the 1.5 percent gain in the core personal consumption deflator in 2011:Q1, but we are concerned that higher food and energy costs are presenting a warning signal on the inflation front. The rise in food and energy costs fueled dangerous 3.8 percent advances in both the personal consumption price index and the all-important price index for gross domestic purchases (products bought by U.S. consumers and businesses) in 2011:Q1. In both cases this increase was the biggest advance for these inflation measures since 2008:Q3. Moreover, the inflation data show that we are importing inflation in the service sector, as witnessed by the 4.5 percentage point advance in the price for service imports last quarter.
Accordingly, the latest data suggest that higher food and energy costs in places like Asia has started to fuel a rise in core import prices. This rise in import prices, combined with higher energy, apparel, vehicle, and renters costs in the upcoming months is now projected to boost year-over-year headline consumer prices to the 3.5+ percent area by the late summer, while year-over-year core consumer inflation could accelerate to the 2 percent area by the early fall. If realized this should fuel a change in the Fed thinking about the future direction of monetary policy as the hard-line hawks at the regional Fed districts will become a bit more vocal on the Fed’s need to “remove the punchbowl” and begin to tighten monetary policy later this year. Net, the capital market’s somewhat euphoric response to the Fed’s press conference following this week’s FOMC meeting could be tested in a few months.
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