MARKET EARNINGS
As we near completion of the 1Q01 reporting season, there seems to be no meaningful change in the patterns in negative pre-announcements and downward revisions in earnings estimates.
The most ominous trends continue to be the level of 2Q01 negative pre-announcements and the rate of downward revisions in 4Q01 earnings estimates for the technology and basic materials sectors.
The most favorable trend continues to be the limited number of negative pre-announcements and minimal downward estimate revisions in the consumer cyclical sector. Also favorable was the 1Q01 return to more normal patterns in earnings surprises, from the below normal patterns in 4Q01.
With 81% of the S&P500 having reported, earnings are only down 5.2% from the strong 1Q00 quarter. However, as the major April ending quarter companies report that number will move to a deeper loss. Wal-Mart is expected to be only a penny above year-ago earnings, Home Depot and Dell Computers are expected to be down modestly, and Cisco Systems, Hewlett-Packard, and Applied Materials are expected to be down substantially. The estimate for 1Q01, using the actual results for the 81% and estimates for the remaining 29%, is a decline of 7.0%.
Given that the remaining companies will likely slightly beat the estimates, and baring any major surprise from one of the aforementioned tech companies, the final number will probably be a decline of about 6% from 1Q00 earnings. That is partly because the actual results are coming in on average 3.4% above the estimates at the time each reported. While that is in line with the average of the last seven years, it is better than the 0.9% in 4Q00.
The number of companies beating (57%), matching (28%), and falling short of (15%) estimates (at the time each company reported) provide little cheer. The number beating is in line with the seven year average. Somewhat fewer companies are matching rather than falling short, but that is only because there was a record number of warnings for 1Q01, so some of the falling short was taken care of by earlier warnings.
The real 1Q01 measure is that expectations at the beginning of the quarter was that earnings would be up 5.3%, yet final results are zeroing in on a decline of 6% to 7%.
Most worrisome for earnings in the remaining quarters for this year is the level of negative pre-announcements for 2Q01. Since 1 April, there have been 242 warnings for 2Q01. At the equivalent point (27 Jan) in 1Q01, there were 127 warnings for 1Q01. That means the pace of 2Q01 warnings is almost double that of the record setting 1Q01.
The concern raised by these warnings is not their impact on 2Q01 estimates, but their impact on analysts’ revising their 3Q01 and 4Q01, and whether warnings will be at a similar pace for those two quarters.
The technology sector also set a new record for warnings in 1Q01, but by a much wider margin than did warnings for all companies. Tech warnings beat the prior record set in 4Q00 by 71%, while the overall universe beat the prior record by only 24%. Despite this surge of tech warnings for 1Q01, the tech sector warnings for 2Q01 are 91% above the 1Q01 record setting pace.
Meanwhile, tech sector earnings for the remaining three quarters of this year continue in free fall. Since the beginning of April, the expected S&P500 tech sector year-over-year earnings growth has fallen from a 35% decline to a 50% decline for 2Q01, a 23% decline to a 37% decline for 3Q01, and a 1% gain to a 12% decline for 4Q01. Estimate reductions for the economically sensitive basic materials sector (papers, metals, chemicals) are also in free fall for all three remaining quarters.
We continue to believe that the critical earnings data to monitor is whether there is any change in the warnings and revision patterns for the consumer cyclical sector and for the technology sector. One indicates if the consumer is continuing to spend and will pull the economy out of the doldrums, while the other indicates if the slow capital spending will pull the rest of the economy into a recession.
At present, there are no signs of a change in the patterns in either sector. Stay tuned.
Obviously, the market will be dependent on the outcome of this battle between consumer spending holding up and capital spending continuing slow. But in any event the market does not look cheap. The inverse of the 10 year bond yield of 5.19% implies a fair market P/E of 19.3. The current P/E is 22.3, implying the market is about 16% overvalued if the analysts’ current projections for the next four quarters hold.
Given the risk that the E in the P/E might be significantly reduced, a 16% premium does not make the market seem enticing at current levels.
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