Uh oh. COMPLACENCY ALERT COMPLACENCY ALERT
The Wall Street Journal just ran an article saying Q3 earnings will be poor but it doesn’t matter because the Fed is pumping in liquidity. Unfortunately weak earnings most definitely do matter because Fed pump priming won’t boost GDP much if we continue to pursue anti-growth regulatory and fiscal policy (which makes the presidential election critical for investors). And the widespread notion that stocks simply floated higher over the last three and a half years on a sea of liquidity is false; stocks only climbed about as much as earnings increased. So the PE, in fact, did not expand much. The bull market was an earnings story, not a liquidity story.
The talk of the Street is that Q3 S&P profits are expected to decline slightly year-on-year, which is surprising to some because the U.S. is not in recession. But it is not surprising to us; more than a year ago we were forecasting 2012 S&P EPS of $102, which is about where strategists are now. (We later went as low as $99, which hopefully was a bit too bearish). S&P is not GDP. When net margins are at record levels and global GDP growth slows, it is not at all surprising that a combination of weak revenue (driven partly by declining commodity prices) and margin pressure would cause profits to decline slightly even though GDP growth is still positive. This is roughly what happened in the Asian financial crisis of 1998 – despite much more robust U.S. GDP growth than we have now.
Themes for third quarter earnings:
- Q3 earnings will indeed be weak, but not much weaker than investors now expect. The quarterly “profit wild cards” such as currency, oil prices, and Wall Street results are relatively benign this quarter. Investors are already braced for poor earnings, and our read of the “early reporters” (companies with a quarter ending in August) is that earnings were soft but not terrible. We had strong reports out of homebuilders, certain tech companies (ORCL, Accenture), and a financial (Discover). But stocks leveraged to global growth (FDX, NKE) fared poorly. The domestic consumer is weak but not a disaster (AZO, BBBY, GIS, CAG, MAR).
- Where we expect the weakest results and the biggest estimate cuts are globally exposed cyclical companies. Europe is in a severe recession that is getting worse. ECB bond buying will not save the real economy, but fiscal austerity will hurt it (Krugman is not always wrong). Meanwhile the BRICs continue to crumble. The situation in China is opaque but clearly worse than expected, with weakness extending well beyond public investment to the consumer sector.
- Therefore many global industrials will have poor earnings, as illustrated by recent news out of UTX, EMR, and CAT.
- One of the stronger sectors will be housing related stocks, including banks leveraged to housing. This is a good investment theme but is not big enough to drive overall S&P earnings.
- We don’t love their underlying fundamentals, but consumer staples’ earnings will be helped by weaker commodity prices (apart from corn and meat) and a weaker than expected dollar. The broad Fed dollar was 2.9% weaker in September than June, so Q3 guidance was based on too-bearish currency assumptions. Big pharma will also benefit significantly from a weaker greenback.
- Corporations (but not governments) have extra money to spend on improving efficiency, and the results of Oracle and Accenture suggest they are spending it. That’s broadly positive for enterprise technology companies, such as IBM and Cisco. But PC demand is weak for both secular and product cycle reasons, a negative for some chip stocks.
Bottom line: After all the hype about “first down earnings since 2009,” we expect the media to conclude that Q3 results were not as bad as feared. However, forward estimates will continue to drop. The 2013 bottom-up estimate is $116; $106 looks more plausible, and if we go over the dreaded fiscal cliff $100 is a distinct possibility.
It is not really “typical” for companies to provide forward guidance for the coming year when they report Q3 results in October and early November. But we expect fewer companies than usual to provide 2013 guidance when they report Q3 results, for two reasons. The global macro picture is exceptionally opaque and potentially even worse than it appears (particularly China), and, secondly, the U.S. election and fiscal cliff create extreme policy uncertainty in the U.S.
