Wednesday, February 20, 2013

U.S. Earnings Insight

With approximately 87% of the S&P 500 companies having reported 4th quarter 2012 earnings, it has become clear that the 4th quarter will be the second consecutive quarter in which operating earnings are lower than in the same quarter of the prior year. While much has been made about the fact that the vast majority of companies have beaten estimates, investors would do well to remember than a little more than a year ago, bottom up consensus estimates called for earnings growth in excess of 19%. True, 4th quarter operating earnings were hindered by a number of companies changing their pension accounting methodology, but the fact remains that over the last 12 months, expectations for 4Q12 earnings declined rather dramatically and most of the decline occurred well in advance of company decisions to alter pension accounting. In that light, this earnings season is a rather significant disappointment. With the vast majority of companies having reported, it is also clear that operating earnings growth for 2012 will be less than 1%. As our chart indicates, S&P 500 operating earnings over the last four quarters is actually about 1.75% lower than it was over the four quarters ending last June. That is far from a disaster, especially given the speed at which earnings grew from mid-2009 through mid-2011. However, it is clear that earnings growth has been decelerating significantly over the last six quarters. 

While consensus bottom up operating earnings estimates for 2013 have declined significantly since the start of the year, we continue to believe that they remain far too optimistic. Not surprisingly, estimates have fallen most for the 1st quarter with smaller declines for each of the subsequent two quarters. Consensus for the 4th quarter has actually risen modestly. That is not surprising given analysts’ proclivity for optimism and the fact that over the last six quarters analysts final consensus estimates for quarterly earnings have consistently fallen significantly from their initial levels. In short, analysts have consistently and significantly overestimated earnings power, forcing them to reduce their estimates over subsequent, quarters. Ultimately, they have reduced them slightly too far and as a result, the majority of S&P 500 companies have beaten final estimates over the last six quarters. Another result is that investors and market pundits, suffering from short-memories, describe the earnings season as strong because the majority of companies beat final estimates.

Currently, bottom up consensus for 2013 S&P 500 operating earnings are for $111.28/share, or an increase of approximately 14.5% over 2012 operating earnings. Even taking into account the impact of accounting changes on 4Q12 earnings, this expectation is ridiculously optimistic, as is the 2014 consensus of $125.71/share, which 13% above the 2013 consensus. Essentially analysts seem to think we are in a lull that is bound to get better, but that rationale holds little support. Consensus estimates of earnings growth for 2013 and 2014 are above the median level of just about 12% over 93 rolling annual earnings periods (rolling by quarter) dating back to 1989. Government deficits contribute to earnings and that fiscal policy is tightening. The end of the payroll tax holiday will cut disposable income for the median household by approximately $1,000 this year and the top income tax bracket and top capital gain bracket has been raised. Sequestration, which is set to take place on March 1, may yet be averted, but if so, it seems likely that there will still be some additional spending cuts. In short, fiscal policy is tightening and the immediate impact is negative for corporate earnings growth, which has weakened significantly over the last six quarters. Additionally, global growth remains weak and US companies have little fat left to cut. Given these facts, consensus bottom up earnings forecasts for 2013 and 2014 seem almost risible.