KFS WEEKLY COMMENTARY
Four times a year, investors focus on the most fundamental driver of investment
performance: earnings. Unfortunately, like the economy, earnings growth remains
sluggish. The first quarter of 2013 is likely to mark the fourth quarter in a row
of low to mid-single-digit earnings per share growth. The dollar amount of earnings
per share for the S&P 500 companies is expected to be lower than in each of the
past three quarters and only 1% higher than a year ago, according to the Wall Street
analysts’ consensus complied by Thomson/Reuters.
The sluggish growth rate for S&P 500 company earnings reflects not only slower growth
among individual companies sales with revenues also expected to be up only 1% from
a year ago, but also reflects the shrinking number of companies expected to post
any growth in earnings at all, with four of the 10 sectors expected to reveal declines.
The Institute for Supply Management (ISM) is one of the best leading indicators
for the economy and markets. The ISM is a group that represents purchasing managers
at U.S. corporations. The ISM surveys these purchasing managers each month and publishes
the results in the form of an index. Although manufacturing businesses make up only
about 40% of S&P 500 company earnings, demand for manufactured goods has been a
timely barometer of business activity of all types.
Currently at about 51, the ISM suggests a sluggish environment for profit growth.
The level of the ISM index indicates that earnings growth may be slightly positive
this quarter, but unless it picks up meaningfully – which seems unlikely given a
soft U.S. consumer and the broadening recession in Europe among other challenges
– profit growth is likely to be only half as strong as the consensus expects in
So far, 29 companies of the S&P 500 have reported earnings. This week, 74 companies
are scheduled to report, with about half of the 500 companies due to report by the
end of April. While investors are very focused on what the profits were for the
past quarter, it is what they may turn out to be over the next several quarters
that will likely have the most impact on the markets.
Much like last year at this time, estimates for earnings growth in the third and
fourth quarter are in the double-digits. In contrast to those lofty expectations,
last year earnings growth in the second half ended up averaging just 3%. Again this
year, the estimates for the coming quarters are likely to come down as earnings
remain bound by the sluggish economic growth driving revenues. Analysts’ 10% third
quarter 2013 and 13% fourth quarter 2013 year-over-year earnings growth expectations
are out of sync with their much lower 3% revenue growth forecast for the second
half. Given weak productivity growth and already wide profit margins, it is unlikely
companies can produce double-digit earnings growth on low single-digit revenue growth
later this year.
However, we may not see major downward revisions to earnings estimates in the coming
weeks as first quarter reports come in. Despite being way too high last year, earnings
growth expectations only came down about 1 percentage point during the first quarter
earnings reporting season of last year. The likelihood of more gradual downward
revisions to growth expectations is one of the reasons why we still believe another
sharp 10-20% decline in the market – similar to those seen in the spring of each
of the past three years – is unlikely. See our March 25 Weekly Market Commentary:
10 Indicators of a Spring Slide in the Stock Market for more insights on our view
of the conditions needed for a major market decline.
What We Are Watching
Earnings may come in better or worse than expected for the quarter, depending primarily
on factors that are hard to predict.
U.S. consumers have benefitted from a return to all-time highs in the stock market
and the return to a strong housing market – these factors combined to result in
strong consumer spending growth in the mid-2000s. On the other hand, the combined
drags of higher taxes, high gasoline prices, sluggish job and income growth, and
the overhang of more fiscal cliff battles to come may have weighed on spending.
We will be watching to see how these drivers may have offset each other in the
first quarter, especially relative to the high expectations for the consumer discretionary
About 40% of S&P 500 corporate profits are derived from global sources. Asian economies
experienced improving growth in the first quarter of 2013, while Europe’s recession
lingered. The extent to which these factors offset each other across different sectors
will be worth noting since the trend may continue for much of this year.
Investors are displaying the greatest confidence in continued earnings growth they
have had in the past few years. This can be seen in the stock market rally lifting
the price-to-earnings ratio, or what investors are willing to pay today per dollar
of earnings over the past four quarters, to 15.3. This is now just above the long-term
(since 1927) average of 15.1. The higher the price-to-earnings ratio, the brighter
the implied outlook for future earnings growth.
While the rise in the price-to-earnings ratio to the long-term average suggests
stocks can no longer be considered cheap, they are not expensive. Since WWII, every
bull market has peaked with a price-to-earnings ratio of 17-18, with the exception
of the late 1990s/early 2000 bull market that peaked at a much higher 28. From a
valuation perspective, this suggests the S&P 500 could rise another 13% to 1800
without the benefit of any earnings growth before the stock market could be considered
expensive and at significant risk of a bear market.
All that said, we would not be surprised at a modest stock market pullback of 5
– 10% as the earnings season offers us a reminder that although a fiscal crisis
in the United States and Europe may have been averted in the first quarter, it did
come with a cost in the form of growth.