The first quarter is about to close, and shortly we will be entering earnings season. As Larry Kudlow, the economist and CNBC television host, often says, "Earnings are the mother's milk of stock prices." Certainly, earnings have been very strong and stock prices have followed. S&P 500 earnings were $98 for 2012. Four quarter earnings per share at the end of March 2009 were $43. That is a 129% increase in annualized earnings. Is it a coincidence that the S&P 500 was up 128% in the same time period? We would argue that there are many factors that affect stock prices. Currently, investors seem willing to take on additional risk and valuations in terms of price earnings ratios are rising. On close examination, the 38% rise in the market since the end of September 2011, only 1% of it was due to earnings. Nonetheless, earnings are a fundamental element of stock prices. We will be watching earnings announcements as an important indicator of the direction of market. So what can we expect for this quarter and those that follow?
The Bureau of Economic Analysis just published its first estimate of US corporate earnings for Q4 2012. At 14.4% of national income, corporate earnings are at their highest level since the 1960s, justifying a high P/E ratio. With corporations having little or no pricing power during the recession, profit margins were raised by cutting costs, the largest of which is labor. Declining real incomes and wages meant enhanced productivity growth and robust profits. However, the Bureau of Labor Statistics reports that during the fourth quarter productivity growth declined 1.9%. This decline combined with a 2.6% rise in hourly compensation means that unit labor costs rose at a 4.5% annual rate. We do not know if we have seen the peak in profit margins in this cycle, but the price earnings ratio of the S&P 500 declined on average in the twelve months after the peak in margins in the nine previous recoveries since the early 1950s.
Increasing problems in Europe, where US companies generate 17% of their profits1, may not help US companies. After strengthening in 2012, both the euro and sterling are now weakening against the dollar. Multinationals will soon feel the effects of a stronger dollar as foreign earnings and export revenues translate into fewer dollars. These effects may appear as soon as the first quarter.
Although profits for large companies are running at historically high levels, small companies continue to struggle. The National Federation of Independent Business, which surveys small businesses, reported this month that 13% of small employers had higher profits quarter to quarter (unchanged), and 43% had declining profits (up 3%). Only 7% said their credit needs were being met. So while unit labor costs may be rising within the S&P 500, there appears to be little hiring pressure from small companies, where we would expect to find job growth in an expanding economy.
Coca-Cola reported that fourth quarter volume was up one percent in North America, down 4% in China, where it had been up 10% the previous year's fourth quarter, and down 5% in Europe. McDonald's same-store sales fell 1.9% in January and another 1.5% in February due to weakness in China, Japan, Europe, and the US. Analysts' earnings estimates moved higher each of the last four years to then begin a decline as company guidance reduced investor expectations. Both Oracle and FedEx recently reduced guidance for the coming quarter. We hope that is not an omen of things to come.
Since many Wall Street Analysts seem congenitally optimistic, it would not be surprising or unusual for actual earnings to come in below current Thomson consensus estimates of $112 for 2013. $112 represents a 15% increase over 2012 earnings. First quarter earnings will be an indicator for the rest of the year. A minor disappointment now might not move the market significantly, but we will be watching.
John Hess Managing Principal (203) 655-4700 jhess@nsinvestors.com www.nsinvestors.com | Falgun Jariwala |
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1. Gary Shilling'sInsightMarch 2013