Below is an excellent fundamental analysis by my good friend Brian Gilmartin of Trinity Asset Management. Brian is a prolific writer for his site Fundamentalis (where the article was first posted) with a keen market sense. Around earnings season, we can count on Brian for some of the best analysis around.
Per ThomsonReuters, the “forward 4-quarter” estimate this week fell to $118.94, from last week’s $119.04; however the year-over-year growth rate rose to 6.34% this week from last week’s 6.04%.
The p.e ratio on the forward estimate is now 14.3(x).
The “earnings yield” on the SP 500 is 6.98% after this week’s rally, and the Fed Model Spread, which we chart weekly as the difference between the earnings yield on the SP 500 and the closing yield on the 10-year Treasury each Friday, is now 4.6%, versus the record highs of early July 2012, when the Fed Model was a whopping 665 – 675 bp’s favorable to equities – and the earnings yield was briefly over 8%.
As was mentioned, the growth rate of the forward estimate rose to 6.34%. The highest recorded year-over-year growth rate since early 2012 was 7.30% in mid-September 2013. We need to break over 7.30% for me to have high conviction that the SP 500 will continue to solidly advance once again. (We always have doubt, it is just the degree of doubt that varies….)
SP 500 earnings growing at roughly 6.5% for calendar year 2013 (ThomsonReuters currently estimates full-year SP 500 earnings growth at 5.7%) are in line with their pos- WW II long-term growth rate of 7%, with the probability that SP 500 earnings will modestly strengthen over the coming year as corporations battle the horrid fiscal policies and the confidence-destroying antics emanating from Washington.
Remember, Corporate America, particularly the SP 500, can’t “control” revenues: top-line growth is a function of product / service demand and the economy. Corporate America does have complete control over “expense” growth, and it is one way to manage earnings (lower compensation, less hiring, lower spending on SG&A). We have spreadsheets on 80 – 100 of the SP 500, and I guarantee you that in this environment, Corporate America is throwing expense and capex dollars around like sewer covers. Washington just doesn’t get it: the US economy is about growth, and it remains sub-par.
Q3 ’13 earnings are lapping the weakest SP 500 earnings growth from q3 ’12, which was just +2%. The probability remains better than average that we see a 7% – 8% quarter of earnings growth this quarter, which will only average to +5%, if we combine q3 ’12 and q3 ’13, (or what is better known in retail as the 2-year comp). 8% earnings growth seems far-fetched given the headlines and the sentiment, but Europe is now stable, Japan is improving, and the US dollar was weaker through q3 ’13, particularly versus the euro and the yen.
Why monitor the growth rate of the “forward 4-quarter” estimate ?
In a nutshell, the reason we track the forward estimate growth rate and year over yyear change is that (in my opinion) it is the one metric that validates or “explains” an expansion (or contraction) in the SP 500′s p.e ratio, or what is otherwise known as P.E expansion. Although I can’t prove it mathematically, it seems intuitive that if the growth rate of the forward estimate is increasing, then the SP 500′s p.e ratio can “expand” to keep pace with the presumed acceleration in “earnings expectations” (or contraction) as the forward growth rate slows.
Just like the bond market and the Federal Reserve are more concerned with “inflation expectations” than actual inflation that we can see in the data, I think the one component missed by strategists and the CNBC community is “earnings expectations” and the growth therein. The one metric that quantifies this expectation is forward earnings, yet we hear about it so very little.
Are there errors with this model or methodology? You betcha, and it was a big one in 2008. The SP 500 forward earnings metric didn’t peak out until July 2008 when the forward estimate topped at $102 and change. When we look at our old data and see that the July 4th, 2008, forward estimate was $104.07 (the high point for the SP 500 until late 2011, early 2012, when that estimate was exceeded), we remained bullish for far too long into the 2008 – 2009 recession based on earnings data and despite what “market action” was telling us. (Warren Buffett’s classic saying comes to mind, “Beware of geeks bearing models.”)
So what is the lesson learned ?
Every model (including any and all market and stock valuation models) are flawed in some way. Every investor should have their own style and methodology, but it shouldn’t be relied upon exclusively. We think studying the SP 500 earnings data from ThomsonReuters and Factset are very important inputs to the market and individual stock valuation exercises, but we also use technical analysis and (hopefully) good old fashioned horse sense to arrive at our market conclusions and portfolio holdings.
Today, based on low expectations, we think that SP 500 earnings and forward expectations of SP 500 earnings remain a net positive for the stock market, and we think it highly likely that over the next 12 – 14 months, SP 500 earnings and earnings growth will contribute positively to SP 500 performance. Although the US economy is growing at a sub-par rate, the fact is that the economy is relatively stable and just about every asset-class excess of the last 25 years (with the exception of possibly bond funds and bond investing) has been shocked back into normal expectations about long-term investing risk and reward.
In the next week or two we are going to publish a study of the SP 500 earnings since the mid-1980′s, showing both dollar estimates for the years and the returns for the SP 500 therein. You’ll probably be surprised at the data and the SP 500 performance relative to the data.
Stay tuned.
Staying with Financials:
One of our assumptions for q4 2013 was that Financials would outperform based on expectations for earnings growth and normal capital market and SP 500 returns for the last quarter of the year, which is traditionally the strongest of the year in terms of “average” SP 500 returns. We remain long ob names like Goldman Sachs (GS), Schwab (SCHW) and JP Morgan (JPM) given their capital market and asset sensitivity to the market returns. We also like CME, Wells Fargo (WFC), and Bank of America (BAC). Names on the radar currently not owned are Morgan Stanley (MS), Ameritrade (AMTD), and Chicago Board of Options Exchange (CBOE).
Here is the full-year earnings expectations data for the Financial sector for calendar year 2013 per ThomsonReuters:
10/11/13: +19.8%
10/1/13: +20.1%
7/1/13: +18.1%
4/1/13: +15.4%
1/1/13: +16%
Financials are the only SP 500 sector to see earnings estimates INCREASE during the course of 2013. Some of that is reserve releases, as consumer balance sheets are much healthier today than at any time in the past 3 years, while some is the capital market returns generated by an SP 500 that was up 19% as of September 30, which has helped reinvigorate the IPO market and M&A (to some degree).
For Q3 ’13 and Q4 ’13, here is the trend in quarterly earnings growth expectations for Financials:
10/11/13: +8.6% and +24.3%
10/1/13: +9.4% and +25.2%
7/1/13: +12.5% and +25%
4/1/13: +11.3% and +24.6%
1/1/13: +12.2% and +26.1%
For Q2 2013, Financials saw their initial +20% growth escalate to 30% by the end of July after reserve releases and trading revenue data were revealed in the financial results.
Relative to the SP 500, Financial sector earnings are growing at 2(x) the rate of the SP 500 at lower p.e ratio’s for the stocks and the sector as a whole.
Pundits attribute the reserve releases negatively, saying a release of a credit reserve isn’t “earnings” but not saying that when the reserve is increased, there wasn’t a reduction in earnings. In other words, they aren’t treating reserve additions and releases equally in the quality of earnings discussion. Tom Brown, whom I like and read regularly, makes the exact same point on his blog, www.bankstocks.com. You can’t have it both ways.
For me, the right way to look at bank valuation is on pre-tax, pre-provision profits, or what is called or known as PTPPP (it is similar to operating income for an Industrial or Non-Financial).
There are about 10 weeks left in the trading year for 2013. We should see Financials start to move shortly. Our plan currently is to reduce some of our Financial weighting by the end of Jan ’14. I don’t think 2014 will see the same level of earnings growth for the sector. If we do not start to see a move in Financials by the week of 10/18 or at the very latest by 10/25, we have to re-think our positions.
Conclusion: Since Oct 1, q3 ’13 earnings growth expectations have fallen from +4.6% to +3.8% from October 1 to October 11. This is somewhat unusual, since the pattern has been that earnings growth expectations get revised too low, and then once earnings start to get reported, the expected growth rate starts to tick higher. The biggest drag is Energy, which has seen q3 ’13 expected earnings growth for the sector fall from -0.7% on 10/1/13 to -4.7% as of 10/11/13. Both Chevron and Exxon Mobil face easier compares in q3 ’13, which tells me that Energy estimates might have gotten too negative in the last few weeks.
Only Utilities has a higher expected growth rate for q3 ’13 as of 10/11/13 than 10/1/13, with the expected sector growth rate of 0.9% versus 0.8% on 10/1.
Only 29 companies have reported q3 ’13 earnings per ThomsonReuters, but by the end of next week, or October 18, there will be close to 100 reports. This coming week will be a better tell in terms of results.
Interesting metric: for q4 ’13, only Industrials have seen their expected sector growth rate revised higher since October 1,’13, from +17.3% to +17.7%. Not a large amount, but it is the direction that sticks out. The other 9 SP 500 sectors saw downward revisions to expected q4 ’13 earnings growth, which is more “normal.”
