A Macro Look at Earnings Season

Weekly Market Commentary 4-16-12

The markets have had a great start to the year. The S&P 500 was up 12.6% for the first quarter, making it the best first quarter since 1998. Now the focus will be on company earnings with the first quarter earnings season getting underway.

As of Friday only 24 companies have reported, but the numbers and responses have been overall positive. According to Bespoke, the average one day change in the price of the stocks that have reported earnings was 2.54% and 75% of companies beat earnings. If you remember from some of our prior market commentary, this is on the high end for earnings beat rate.

We believe companies are continuing to beat earnings expectations for two main reasons, record high profit margins, and fairly low expectations.

Corporate Profits

US corporate profit margins are the highest they have ever been in post-war history. The graph below provided by a recent white paper by GMO shows the breakdown of what is currently driving these record profits.

US corporate profit margins and their macro-drivers

As you can see, corporate profits have historically been driven by Net Investments (buying real assets), but lately it’s been driven more by the Governments fiscal deficit. Government savings contributes positively to corporate profit margins because they have a negative savings rate (a double negative is a positive). This negative savings rate is good for corporate profits right now, but probably not sustainable in the long run because it increases the deficit. If we expect these record profits to continue we need more people consuming more goods.

Once again consumption appears to be the key. If we continue to have an improving macro economy and the consumer’s animal spirits come out, these higher profit margins could be here to stay. The flip side is for these record profit margins to revert back to the mean. If their propensity to consume isn’t big enough, then I would expect these profit margins to fall back towards the mean over the next few years.

adjusted after-tax corporate profits

Analysts Expectations

Analysts have been bringing down expectations for this quarters earning growth since the beginning of the fourth quarter last year. Initially it was 8%, then fell to 3% at the beginning of the year and as of last Friday it stood at 0.0%. If you take out Apple earnings growth rate for the S&P 500, then the earnings growth rate drops to -1.5% for the quarter.

With 0% earnings growth you might be wondering how the stock market just had its best first quarter in over a decade. We believe the answer is the fact that the market is a forward looking indicator. According to FactSet analysts are calling for double-digit earnings growth in Q4 of this year and Q1 of next year as the economy continues to strengthen.

s&p 500 estimated earnings growth rates

Despite what you might be hearing about economies abroad (a hard landing in China, and European Financial Crisis’s) U.S corporate earnings are still intact, at least for the moment. Whether we continue to have record profit margins or double digit earnings growth only time will tell. But with 3% GDP growth in the fourth quarter and recent upward revisions to the first quarter GDP estimates we can say that our economy is at least moving in the right direction.

If you have questions or comments please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can Email us directly.

Adam Gulledge, Associate Investment Advisor – Phillips & Company