- Without question, investor attention has been focused on the political and macro events both here and abroad during the second quarter earnings season. In large part, this has proven to be a painful distraction from the continuation of strong earnings and revenues being produced by corporate America.
- The challenges in Europe have reached a breaking point and a wake-up call to the leaders in Europe has been made.
- Eventually the dust will settle and favorable fundamental factors—earnings and revenues—should provide support for at least the domestic equity market. Moreover, the S&P 500 Index is now cheap relative to historical valuations and Treasuries.
In contrast to the first quarter of 2011, when good earnings results served as a catalyst to move the stock market higher, the most recent good earnings reporting period has been more than offset by concerns associated with our debt limit/budget discussion in Washington, renewed fears of a double dip in the U.S., and, most importantly, an increasingly worrisome environment in Europe. As painful and difficult as the last several days have been, the growing reality check of the problems in the “club med” countries in Europe should provide a necessary wake-up call to the monetary and fiscal policy leaders on the other side of the Pond as Europe has hit a brick wall. Despite fears about the economy, the latest employment data shows that the domestic economy is still in a growth mode which should keep the earnings engine running.
For several months and years it has been clear that European monetary policy union was not working. Greece and Portugal do not appear to be able to pay back their debts and a Brady bond like restructuring that would include a significant haircut for current investors is still a likely event. In recent weeks the financing challenges of Spain and Italy, along with the cross-ownership concerns of financial institutions in Europe, have sparked fears about another financial crisis for Europe. The European Central Bank met this past week and did nothing to address this issue. This continued hardline policy stance, along with a decision by German officials to oppose additional bond purchases by the ECB and an expansion of the European Financial Stability System (EFSF), exacerbated the selling in the equity markets on August 4 and the morning of August 5. The panic selling brought back fears of the fall of 2008 but was even more reminiscent of what unfolded last spring in the flash crash and during the Russian default crisis in the fall of 1998. The new challenges over the last several weeks include the fact that Italy and Spain have moved to the front and center of the European debt crisis as both countries need to implement fiscal policy restraint and obtain underwriting support from European entities.
Late Friday Italy’s Prime Minister Berlusconi announced that Italy will introduce a balanced-budget amendment and speed up its fiscal consolidation timetable. Although this announcement tempered the selling in the equity markets, market participants were still eagerly awaiting the outcome of the meeting between Sarkozy and Merkel and hoping for a change in the hardline stance by the Bundesbank. The ECB needs to hit a restart button that includes a restructuring of the debt of Portugal and Greece and a financing mechanism for Italy and Spain. Although the U.S. equity market has been a hostage to these events, at some point a solution will be formulated (possibly including an expansion of the EFSF allowing for the purchase of Spanish and Italian debt) fundamental factors should reemerge in the U.S. equity market that determine equity market valuations.
For European financial institutions liquidity has clearly been a challenge. However, this is not the case in the United States. Domestic banks are awash with liquidity as witnessed by the fact that several domestic banks are now charging large customers to hold demand deposits. High cash balances of both potential investors and corporations, attractive dividend yields, and modern-day record low yields for short-maturity Treasury issues should eventually bring buyers back into the equity market. The sharp sell-off in U.S. equities is likely to provide active managers with an opportunity to buy good companies, with good earnings at an attractive sales discount.
With 83 percent of companies in the S&P 500 Index having reported results, over 75 percent of them have beaten their earnings estimate. In fact, this quarter’s earnings surprise rate is turning out to be one of the strongest since the middle of the decade, even outpacing the historically high 65 percent surprise rate that has been witnessed over the last two years. With all of the fears in the capital markets, the aggregate earnings growth for the S&P 500 Index is more than 18 percent for the quarter. Revenue growth is often viewed as a driver of future business performance and is a key indicator of the health of the economy. In line with our long-standing view that companies are doing better than the economy, 72 percent of companies have beaten their revenue expectations with the aggregate surprise rate at over two percent and revenue growth in aggregate above 13 percent for the latest quarter, significantly better than the 3.7 percent nominal GDP gain. Revenue growth is being achieved broadly across the economy as well, with a good portion of this gain coming from non-European overseas operations. Outside of financials, revenue growth this quarter spans from 6.4 percent in healthcare to 29 percent in energy with technology and consumer discretionary companies notably outpacing expectations by almost five percent.
Interestingly, the uncertainty of the macro environment has not hampered expectations of continued strength at the micro level. Industry analysts have increased their corporate earnings estimates at a rate of roughly three estimates being raised for every two being decreased. The ratio for 2012 is solidly positive as well at 1.36. Despite the concerns in Europe and fears in the U.S., full year earnings estimates continue to march higher with the 2011 bottom-up earnings estimate for the S&P 500 now at $98.89 and the 2012 estimate elevated to almost $114. With the S&P 500 currently trading around 1200, the forward valuation for the Index is just 12.14 times 2011 earnings and only 10.57 times the 2012 number. With profit and revenue growth still expanding for U.S. corporations, those valuation levels have historically been compelling. Volatility in the equity market is likely to continue over the near term but we believe that this can be used as an opportunity. Remember the wise words of Warren Buffett ,“Be fearful when others are greedy and greedy when others are fearful.”
In theory, the release of the employment report for July should have negated some of the worst case fears about domestic economic conditions. Nonfarm payroll employment rose by 117,000 in July, and the unemployment rate declined 0.1 percentage point to 9.1 percent. These readings were significantly better than market estimates centered at +75,000 and whisper number fears of an outright decline in payroll employment. Moreover, the May and June jobs reports were increased by 56,000 workers. Private employment rose a respectable 154,000 last month as manufacturing employment rebounded 24,000, while retail trade, health care, and professional services gained 26,000, 31,000 and 34,000, respectively. The average workweek was unchanged at 34.3 hours, however, average hourly earnings increased by 10 cents, or 0.4 percent, to $23.13. This increase in earnings is likely to fuel a solid rebound in real disposable personal income.
The favorable news associated with this report was largely offset by the fact that market participants are clearly worried that the current economic and financial market chaos in Europe could undermine already fragile consumer and business confidence. A plentiful supply of liquidity in the U.S. banking system and the need for businesses to replenish depleted inventory positions (especially in the auto sector) should provide a bit of a shock-absorber to the domestic economy. We still expect that U.S. economic growth in the second half of the year will improve from 2011:H1 but it will likely be at a slower pace than previously anticipated.