The third quarter earnings season in the US has turned out better than many initially feared. However, the challenges facing the corporate sector over the coming months are significant, and the likelihood is that the rate of profit growth will slow dramatically, or possibly go into negative territory, says William Sels, UK head of investment strategy at HSBC…
Analysts have started to downgrade their expectations for earnings growth but this process is probably far from over. Although valuations currently look undemanding, the current stage of the earnings revisions cycle may not prove to be a good time to tactically increase exposure.
The third quarter earnings season is drawing to a close, and the good news is that there have been few negative surprises. As we write, approximately four-fifths of S&P 500 companies have released results and the numbers suggests that corporate earnings have increased by 15% relative to the same period last year. Moreover, around 70% of the companies that have reported have beaten expectations. This marks the 8th consecutive quarter of year-on-year earnings growth for the S&P 500 index. Looking ahead however, we suspect that this record will be tough to maintain.
Expectations are that US earnings will grow by 16% this year compared to 2010. Given that we are already three quarters of the way through the year, we are confident that this number – or something close to it – can be met. For example, if earnings in the fourth quarter of this year were to be the same as those for the same period last year (i.e. no growth), the full year growth rate for 2011 would still be close to 13%. However, it is not this year’s earnings that are of the greatest concern to markets; what happens to earnings in the next year is likely to be more important. Current consensus estimates suggest that S&P 500 earnings will grow by 10.7% next year, a high number in our opinion given the weak outlook for the global economy. We have seen the level of earnings expectations fall back in recent months, by about 6%. However in our view, this process has further to run as analysts adjust their expectations to make them consistent with a weaker economic growth outlook.
A useful way to track how analysts are adjusting their forecasts is to look at earnings revisions. This is calculated as the number of analysts’ upgrades divided by the number of downgrades. As can be seen in the chart below, earnings estimates tend to follow a pattern that tracks the economic cycle fairly well. This is largely to be expected – one would expect analysts to be more optimistic when the economy is growing and therefore upgrade their forecasts, and vice-versa.
Moreover, the earnings revisions cycle can be a useful gauge of market sentiment; we can therefore use them to tactically time investments into the equity market. As mentioned above, we are currently in a phase of the earnings revision cycle where they are in negative territory. Furthermore, they are also falling. This can be seen in the chart below which tracks the monthly change in the cycle from the end of 2008 to date.
We have looked at how equities have performed historically if an investor purchased the S&P 500 index and held it for 12 months, in each of the four phases of the earnings revisions cycle, using data from 1988 to date. The results can be seen in the table below.
From observing how equities have performed historically, we can deduct that buying the market in periods like the present one (negative and falling earnings revisions) may not offer the best returns. Moreover, historically, the chances of experiencing a negative return from holding the market were higher than in any other phase of the cycle.
Taking a closer look at the earnings revisions ratio for the industrial sectors of the market shows that it has been the more cyclical sectors that have seen the sharpest turn-down. All of the industrial sectors have a “negative and falling” revisions ratio consistent with the wider market, however, the scale of the downgrades has not been evenly distributed. The largest falls of the revisions ratio over the last six months have been seen in the materials, energy, and industrials sectors and this has been matched by the downgrades we have seen to the levels of earnings analysts expect to see. Earnings per share estimates have been cut by 11-12% for the energy and materials sectors; however, the largest reductions have actually been seen in the financials and telecoms sectors.
Although negative, and still falling, earnings revisions are holding up relatively well for the defensive sectors such as healthcare and utilities. Furthermore, the technology sector seems to be quite resilient; expectations for the sector’s earnings for next year have only been reduced by 5%. In our view, these trends are likely to continue for some months as analysts adjust their estimates to a lower economic growth environment.
Economic growth is slowing, and the outlook for next year remains challenging. In our view, current expectations for corporate sector earnings growth do not reflect the weaker growth outlook. Thus, analysts are likely to continue revising down their estimates for some months yet. Historically, this has not proven to be an optimal environment under which to increase exposure to equity markets. In our view, the earnings cycle needs to show signs of “bottoming” before equity positions should be rebuilt within portfolios.