Courtesy of our friends at The Pragmatic Capitalist
One of the primary drivers of the recent stock rally was the consistently “better than expected” economic news. But as analysts have become more and more optimistic we’ve seen more and more mixed news and a sputtering stock rally. Wall Street is an expectations game and as analysts increase their economic and earnings estimates we could continue to see more bumps in the road going forward.
As we enter the very early portion of Q2 earnings season let’s take a moment to update the current outlook. As we mentioned last week there is a strong possibility that further cost cutting will lead to “better than expected” earnings in Q2. It’s important to note that this will not occur due to organic growth or strong revenue expansion, but unsustainable cost cutting. Thus far, companies have been able to outpace the revenue declines with their cost cuts. Don’t be shocked if we see the continuing trend of missing revenue estimates while beating EPS estimates. Analysts, unfortunately, have not accounted for the extreme cost cuts and have been behind the curve at just about every turn during this crisis. There is evidence, however, in the earnings and economic estimates that analysts are beginning to catch up with the ever changing investment landscape.
On the economic front Bloomberg reports:
“Concrete evidence that the economy is out of recession” is essential for U.S. stocks to extend their three-month rebound, according to Barry Knapp, a strategist at Barclays Capital.
The potential for a recovery has gained “widespread acceptance” by economists, investors and traders, Knapp wrote two days ago in a report. Because of this, economic data has become less likely to surpass estimates, he added.
The CHART OF THE DAY compares Westpac Banking Corp.’s index of so-called positive surprises, based on economic data for the last eight weeks, with the Standard & Poor’s 500 Index. The report included a similar chart.
Westpac’s index shows the percentage of U.S. statistics that exceeded the average projection in Bloomberg’s surveys of economists. The indicator peaked at 60 percent, its 2009 high, in the week ended May 1. This month, it fell below 50 percent.
“The most likely part of the economy to show upside momentum is manufacturing,” Knapp wrote. He singled out today’s report on May durable-goods orders as the best candidate to show the recession that began in December 2007 may be ending.
Orders for durables, built to last three years or more, rose 1.8 percent. The average estimate from a Bloomberg survey called for a 0.9 percent decline. Excluding airplanes and other transportation equipment, orders rose 1.1 percent last month rather than falling 0.5 percent as anticipated.
The news is similar on the earnings front, though analysts still appear behind the curve. As of this week analysts are expecting total earnings of $58 for the S&P 500. That’s up slightly from last week’s $57 estimate. I still think that is more likely to come in at $50 as the second half strength fails to deliver, but for Q2 we are likely to see estimates that are again too low. I am seeing a sharp contraction in my expectation ratio as fewer and fewer companies boost their expectations. As I mentioned two weeks ago:
This ratio calculates how real earnings expectations compare to analysts expectations. It is an intuitive leading indicator which turned negative in 2007 and turned positive for the first time in Q4 of 2008. In essence, it calculates whether companies are likely to beat earnings in the future based on current analyst expectations. As you can see, the ER has risen as expectations have fallen. This means that analysts are cutting their estimates too far too fast and companies are outperforming. As we saw last quarter, this bodes well for corporate earnings. Although last quarter was a disaster by any standard, the figures were “better than expected” and triggered the current market rally. I think we could be in for another quarter of the same treatment.
The recent decline in the ratio is a combination of higher expectations and stagnant economic and earnings growth. The expectation bar, is inching higher, in effect. It’s important to note, however, that the recent sharp contraction in the ER is based on very light data. The number of companies currently reporting is very low so this data will carry more weight as we move into the bulk of earnings.
Total net income is expected to decline 36% versus last year while EPS is expected to decline 19%. I continue to expect earnings to come in better than expected in Q2, though a look under the hood will reveal very little organic strength in the figures. 3rd and 4th quarter expectations are currently calling for -22% and -14% declines in earnings. Analysts currently expect 2010 earnings to improve by 30% over 2009 earnings. That looks like a stretch to me and will require a sharp economic rebound. All in all it’s clear that analysts are still playing catch up – particularly on the earnings front, however, as estimates are backloaded in the second half of the year we’re likely to see the bar continue to inch higher and a subsequently more difficult corporate earnings picture as the year progresses.
We should get a number of pre-announcements in the next few weeks so I’ll be updating this data as we get closer and closer to the actual beginning of earnings season.
