Monday, January 9, 2012

Are Earnings Expectations Too Low?

Michael Mackenzie and Ed Crooks of the FT report, Earnings growth falters for S&P 500 (h/t, Abnormal Returns):
US corporate earnings grew at their slowest pace in the fourth quarter of 2011 for more than two years, according to analysts, and are expected to slow even more in the first quarter of this year as profits are hit by global economic economic turbulence.

The US earnings season begins on Monday with Alcoa, one of the world’s largest aluminium producers, reporting fourth-quarter results after the stock market closes.

Expectations of Alcoa’s profits have been scaled back sharply in recent months, and the average analyst forecast is now for a loss. It said last Thursday it would take a $155m-$165m charge in the quarter for the costs of shutting down temporarily or permanently 12 per cent of its smelting capacity as it attempts to cut costs and respond to a weaker aluminium price.

Corporate earnings for the S&P 500 constituents as a whole are set to break a run of eight consecutive quarters of double-digit gains. As the outlook for the world economy has darkened, with the crisis in Europe deepening and signs of strain in emerging economies, expectations for US companies’s earnings growth have been scaled back.

Analysts now expect that average earnings growth for the S&P 500 in the fourth quarter of 2011 over the same quarter in 2010 will be 7.2 per cent. At the start of October, the average forecast was for 14.5 per cent growth, according to S&P Capital IQ.

But the comparison of 2011 to 2010 is helped by AIG, the insurance group 77 per cent owned by the US government, which suffered a big loss at the end of 2010. Excluding financial companies, S&P earnings growth is expected to have been 6.9 per cent in the fourth quarter.

Average earnings growth in the first quarter of 2012 is expected to be just 3 per cent, according to John Butters, senior analyst at FactSet, the financial information service.

“Clearly we are in a cycle of reaching pinnacle earnings and at some point we are going to drop,” he said.

For 2011, S&P 500 earnings are set to hit a record $96.38 per share, surpassing 2007’s high-water mark of $87 a share according to FactSet. For 2012, S&P earnings are forecast to reach $106.67 per share, a rise of 10.7 per cent, on a return to stronger profit growth in the second half of the year. However, that estimate has steadily fallen from $113 a share in August.

Investors remain sceptical about what they see as rosy estimates for earnings from analysts amid doubts about the economy’s growth prospects and the ability of companies to continue cutting costs.

Optimism for the second half of the year is tempered by the fact that such longer-term calls have a greater risk of being wrong.

What is going on? Why are investors still so skeptical? Why was the reaction to Friday's better-than-expected jobs report so muted? While some maintain that all the good news on the US economy is priced in, I think investors are in for a big (positive) surprise.

Importantly, watch Alcoa's (AA) earnings report. I think it will set the tempo and I wouldn't be surprised to see the stock take off as it has been heavily shorted. By and large, I expect positive earnings surprises, which will help propel the markets higher. My favorite earnings indicator, however, is what Google reports. It's a better barometer of the true state of the global economy.

Of course, corporate profit growth is at two-year low as Europe drags on. Merkozy met on Monday to discuss how to boost growth in eurozone states struggling to tackle the sovereign debt crisis and rising unemployment, and to finalize a deal on closer budgetary ties within the currency union. Meanwhile, Bloomberg seized on Andreas Koutras' idea that Greece Bond Plunge Makes Buyback Option Realistic.

I maintain that investors are positioned way too conservatively and they will end up chasing risk assets throughout the year to make up for their underperformance. Europe is not on the brink of destruction. The black swan of 2012 will be that eurozone avoids a deep recession and stocks and other risk assets melt up as central banks pump up the jam.

Below, some comments to temper my thoughts. First, Pimco's CEO and co-CIO, Mohamed El-Erian discusses the muted reaction to Friday's jobs report. I also embedded an excellent interview with Nobel-prize winning economist, Peter Diamond, on why the US needs more fiscal stimulus to spur jobs growth. Listen to him carefully, he's absolutely right, America has yet to address the unemployment crisis.

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