- Roughly 60 percent of the companies in the S&P 500 Index have reported 2011:Q4 results. Although the media has generally portrayed the data as disappointing, the percentage of companies beating earnings expectations has been in line with historical averages.
- The strength of earnings growth going forward has begun to segment somewhat, but annual growth rates continue to remain solid and prospects for 2012 have become a bit more optimistic.
- The S&P 500 Index has risen about seven percent so far this year in spite of misplaced disappointment in corporate fundamentals. Moreover, a hidden story behind these gains is the continued improvement in domestic economic data which provides further support to sustainable, moderate economic activity in 2012.
Without fail, almost every news story or research report pertaining to fourth quarter earnings has centered on the theme of “disappointing” results. And while it is certainly true that the level of earnings growth has trended down from the mid-teen level of the past two years, the pattern of results versus expectations is very much in keeping with historical norms.
Specifically, of the 301 S&P 500 companies that have reported as of February 8th, over 68 percent have delivered a positive earnings surprise which is in-line with the long-term average of 65 percent. Additionally, the magnitude of the aggregate surprise is not far from the long-term average at just over 3 percent. And unlike previous quarters, the overall percentage “beat rate” is moving higher as the reporting season progresses.
Another fact left out of most mainstream media reports is that there are sectors of the economy that exhibited very strong earnings growth in the fourth quarter (as well as some areas that displayed significant weakness). For example, companies within the information technology sector have far exceeded market expectations. 80 percent have surpassed estimates, delivering earnings growth of almost 20 percent, resulting in a surprise level of more than 11 percent. Similar results have been seen in the industrials sector where 82 percent of companies have exceeded expectations and the aggregate growth has been close to 15 percent. The stronger readings in these sectors fit right in line with the industrial-driven improvement in the U.S. economy in 2011:Q4 and the growing signs that this positive traction is continuing in 2012. Conversely, negative year-over-year comparisons have been experienced in sectors that are generally perceived to be more defensive such as financials, utilities, energy and telecommunications (which was heavily influenced by a $4 billion one-time charge incurred by AT&T). In fact, just 27 companies with the greatest decline in earnings accounted for over 100 percent of the decline in earnings per share.
Perhaps more interesting are the revenue results for the quarter. In contrast to the earnings side, reported revenues have been consistently solid across sectors. In aggregate, revenue growth has come in at 6.4 percent led by double digit growth in the technology, energy and consumer discretionary sectors. The surprise ratio has been 1.6 percent and all sectors except for financials and utilities have shown positive sales growth.
This leads to what is likely the most remarkable aspect of the quarter which is diverging paths of earnings and revenue revisions. Forward estimates for earnings have been moving down slightly while revenue estimates have been steadily climbing higher. The earnings trend can largely be traced to weakness in the energy, financials and telecom sectors, however revenue estimates are being increased across a wide range of sectors with the exception of financials and utilities. Although these trends are somewhat counterintuitive, the implication here is that profit margins will be decelerating. Recent improvement in employment data might help explain this, since the hiring of more workers squeezes margins but also helps increase sales.
Finally, at the Index level, growth remains stable with $97 of projected earnings for 2011, a 16 percent increase over 2010, and $105 estimated for 2012, an 8 percent increase versus 2011. Clearly, this earnings season has helped support a surprisingly strong market reaction; the 7-plus percent return is the best start to the 4Q earnings season since 2007 and with somewhat more modest expectations for 2012 combined with increasingly improving economic data, subsequent quarters’ results might have an easier time surpassing what the market is anticipating.
The latest data shows that the U.S. economy improved late last year and the strength in the industrial sector is likely to support moderate economic activity in 2012. Although the headline real GDP print for 2011:Q4 came in a bit below market expectations at +2.8 percent, this still represented the fastest rate of growth since 2010:Q2. A handful of economists voiced concern that a rise in inventories accounted for a significant portion of the growth. However, the inventory expansion was planned and reflected the need to replenish depleted inventory positions following the supply channel disruptions from the earthquake and nuclear disaster in Japan and the unexpected strength in durable goods consumption. Private inventory positions are still almost five percent below their peak five years ago. The “weakness” in the fourth quarter real GDP print was due to a $13.7 billion mild-weather related drop in utility output which represents savings for consumers that could be a source for discretionary spending in the future and a sharp 4.6 percent drop in government spending. The massive hit to government spending was largely due to a 12.5 percent decline in national defense outlays; however, given the increased tensions in the Middle East in recent weeks it will be hard for the government to maintain a double-digit decline in defense outlays in 2012. Although nominal GDP expanded at just 3.2 percent in 2011:Q4, private nominal GDP (excluding the government) rose a solid 4.9 percent, providing an excellent sign that private sector economic activity has improved.
The GDP report, as expected, confirmed our view that the housing sector is now a positive contributor to the economy. Residential investment outlays surged 10.9 percent in the final three months of 2011. Moreover, the latest housing statistics, combined with the continued strength from the industrial sector (auto assemblies are projected to increase about 30 percent this quarter) and a solid rebound in private employment, suggest that the U.S. economy will continue to expand at close to three percent in early 2012.
The employment readings provide yet another sign that the reacceleration in economic activity in 2011:Q4 is continuing into 2012. Nonfarm payroll employment rose 243,000 last month, following upward adjustments of almost 265,000 in the payroll readings during 2011. The strength in the payroll series, including the revisions, was broad-based and included robust gains in both the factory and construction sectors. Likewise, the household series, revealed an explosive 847,000 increase in employment last month (+631,000 excluding benchmark upward revisions), which drove the unemployment rate down to 8.3 percent, from 8.5 percent. Although mild weather probably helped to account for a portion of the latest employment gains and some payback is likely later this spring, the labor report still revealed strong gains in the factory and construction sectors, further supporting the notion that the industrial sector will be a solid contributor to economic growth in 2012. In fact, on a two-year basis, factory employment has expanded at its fastest pace in almost 30 years, providing an excellent sign that this recovery could become self-sustaining with a positive feedback loop from the industrial sector. Near term, the balance of the reading for January should reveal solid gains in industrial output, personal income, and consumption, all of which should bode well for the continuation of moderate private-sector driven economic activity in early 2012.
With the S&P already up almost 7 percent this year, is all of this improving news fully priced into the market? We don’t think so. Although the capital markets will have to deal with continued debt challenges from southern Europe we believe that the macro events that overwhelmed U.S. capital markets in the late spring and summer of 2011 are unlikely to be fully repeated in 2012. Current liquidity conditions in conjunction with continued positive economic developments in several emerging markets and the U.S. argue for near term increased exposure to risk categories such as commodities, credit, real estate and select equity markets. Risks surrounding elections - France, Russia, the U.S. - and governments’ execution of fiscal and monetary policies – in China, U.S., and Eurozone – however argue for careful monitoring events and data releases to determine whether the current positive environment becomes overwhelmed by the intermediate term issues.
Statements concerning Commonfund Group's views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Commonfund Group fund. Such statements are also not intended as recommendations by any Commonfund Group entity or employee to the recipient of the presentation. It is Commonfund Group's policy that investment recommendations to investors must be based on the investment objectives and risk tolerances of each individual investor. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund Group. Commonfund Group disclaims any responsibility to provide the recipient of this presentation with updated or corrected information.