Issue 36 • August 5, 2009 Positive Profit Surprises Drive Stocks Higher
Adding fuel to this bullish run, second-quarter profit reports for S&P 500 companies are coming in better than expected ... or in many cases “less worse” than forecast ... depending on your point of view. In issue 33 of Weiss Advice, I suggested keeping an eye on both the actual numbers AND, especially, on forward looking guidance during this earnings reporting season. Now it’s time for a recap.
First, Here’s the GOOD News ...The majority of earnings reports beat estimates by a wide margin, with quite a few “blow out” reports on the upside. In fact, 71% of firms beat profit forecasts with a few weeks worth of reports still remaining. The earnings “beat rate” is up significantly from the last quarter of 2008, and stands out as one of the best performances in the past 10 years.2 Nearly three-quarters of S&P 500 companies are beating profit forecasts. Not only that, but they’re doing so by an average “surprise” of nearly 9% above forecasts ... which is higher than usual.3
As for guidance from public companies about their outlook going forward ... the jury is still out. Some companies were very upbeat on their outlook for the second half of the year, while others were much more cautious. Overall, 6 firms are revising their profit targets higher for 2009 for every 5 companies that are cutting guidance. For 2010 earnings, the ratio is more like 11-to-10. So while earnings revisions are certainly on the upswing, the magnitude of increase is rather small, especially considering the high ratio of positive earnings surprises (3-to-1).5 Now, for the BAD News ...On the other hand, the collective annual change in S&P 500 earnings last quarter was still underwater at At the start of the second quarter in April, Wall Street analysts forecast profits to plunge 31% year over year. And the estimate slipped to a low of -35% in July, just before the actual numbers began to roll in.7 That’s the reason why actual results — although still negative — have been greeted with so much enthusiasm. Investing is all about anticipating the future. It’s a business of perceptions versus reality. The market’s perception called for a 35% plunge in profits just last month, but the reality was only a decline of about 25% ... delivering a pleasant surprise. Digging down a bit deeper we see that the improvement in corporate earnings has come from cost cutting, by and large, rather than from top line growth, which is a concern. Corporate America is doing a wonderful job at “downsizing” their operations to meet the new reality of slower economic growth. This is both good and bad. While aggressively cutting costs helps the bottom line at individual companies, it also means our collective economy is suffering more job losses, less consumer spending and less business investment on plant and equipment, R&D, etc. This Sector is Showing Healthy ProfitsAs the saying goes, you can only cut so much “fat” before you begin loosing muscle too. You can’t cost-cut your way to growth either. Organic growth as measured by top-line sales revenue has fallen -15% year over year at non-financial companies.8
Still, we are finding certain industries which appear to be bucking the deflationary trend. Defensive sectors, including consumer staples and health care, actually posted positive earnings growth last quarter. Health care firms, for instance, have so far delivered 7% earnings growth year over year.9 This profitable trend is expected to continue next quarter and beyond, according to current estimates. What’s more, health care stocks are among the most reasonably valued in today’s market in our viewpoint, even after the big run-up since March. The health care sector has the lowest price-to-earnings ratio (P/E) for BOTH 2009 (P/E = 11.9) and 2010 (P/E = 10.9) out of all 10 S&P 500 sectors. Rising ExpectationsAs a result of the positive profit surprises, analysts have been busy raising their forecasts for the current quarter and beyond. Third quarter S&P profits are expected to decline ONLY -18% from the same period last year, but there is still plenty of time for revisions between now and October, when the first reports begin to roll in. It’s possible this forecast will again prove too pessimistic, setting up the possibility of more positive surprises ahead. Then again, rising expectations could easily get carried away from economic reality, leading to disappointment down the road. Only time will tell. From a purely technical standpoint, look at the very first graph again. It shows the stock market’s current path in 2009 as compared to 1938. Following this path points to additional upside potential for stocks, but it’s certainly not a straight line, and pullbacks should be expected. I’d like to leave you with a more sobering view (in the final graph below) of what happened to stocks after the robust market rally of 1938. As I pointed out last week in Weiss Advice, the economy, while showing solid signs of improvement, isn’t out of the woods just yet.
While there’s a growing likelihood of positive GDP growth in the second-half, there’s also a strong possibility this rebound in the economy may run out of gas next year. As I have said before: opportunities for profits do exist if you can assume higher risk to get them ... but stay very nimble and keep an eye on the exits at all times. Good investing, 1 Zacks.com: Market News, 8/3/09 Disclaimers: 1. Weiss Advice is a publication of Weiss Capital Management, an SEC Registered Investment Adviser. Weiss Research is a separate, but affiliated publishing company. Both entities are owned by Weiss Group, LLC. 2. "Weiss Advice" is published for general information and educational purposes only and should not be construed as a specific recommendation to buy or sell any security. Specific recommendations can only be given to advisory clients of Weiss Capital Management, with the benefit of knowing their financial condition and suitability. Receipt of this publication should not be construed as a solicitation to do business outside the jurisdiction for which the Firm is approved. Currently, Weiss Capital Management offers investment advisory services to individuals maintaining legal residency within the United States. For details, please contact the Firm. View Weiss Capital Management's Privacy Policy. To make sure you don't miss our urgent updates, add Weiss Advice to your address book. Just follow these simple steps. |
July caped the best five-month rally for the S&P 500 Index since 1938, as the blue chip index added another 7.4% ... on top of its strong performance since the March low.
With the majority of results now in, S&P 500 firms reported profits ahead of expectations for the three months ending in June, but like most other recent economic data ... this is a good news-bad news story.
What’s more the number of positive surprises beat the number of negative disappointments by a ratio of nearly 5-to-1 so far this earnings season.
That’s a clear sign of deflating demand from both consumers and businesses and this is what has us remaining cautious, even as the positive earnings climate is confirming a gradually improving economy. 
