MARKET EARNINGS
The good news marches on, although the continuing record setting pace for warnings is worrisome. Negative pre-announcements for 2Q01 are running 18% ahead of the 1Q01 number on the equivalent date. Maybe even more ominous is the 43% increase over 1Q01 warnings from S&P500 companies.
On the other side of the coin, the minor flurry of warnings and downward revisions in 2Q01 estimates for the consumer cyclical sector appears to have been an anomaly. The news from the retailers the last two weeks as they reported April sales and 1Q01 earnings has been modestly better than many expected.
However, the concern now emerging in this important sector that serves as an earnings proxy for how consumer spending is holding up, is that some analysts in autos and in homebuilding are beginning to raise new concerns about a possible further slowing in autos, and the start of a slowing in homebuilding. These two industries are probably the best canaries in the cage in giving warnings of changes in the consumer portion of the economy. When the consumer cyclical earnings began to be cut last fall, it was the auto analysts who were out front in cutting estimates across their industry, not only for the then current quarter, but for later quarters. Whether this is another anomaly or not will emerge over the next month.
In 1Q01 the market got excited early in the quarter about a 3Q01 recovery in the economy and earnings, but as it became apparent later in the quarter that any substantial recovery in 3Q01 was unlikely, the market backed off. The market is now anticipating a 4Q01 recovery. It should emerge over the next month or so whether that is likely to happen, or whether the recovery again gets pushed back a quarter. However, this time the odds seem meaningfully better that the recovery may in fact happen when the market is expecting one.
In the capital spending area, the tech sector continues in to deteriorate. Warnings for 2Q01 are running 13% ahead of 1Q01 at the equivalent point. Estimates for the S&P500 tech sector for 4Q01 continue in free fall, having dropped from an expected 1% gain on 1 April to current expectations of a 14% decline. Meanwhile, tech expectations for 2Q01 and 3Q01 have fallen to declines of 54% and 40%, respectively. That follows a 41% decline in 1Q01. Worrisome analyst input in this area is from analysts covering the electronic distributors. This industry is a good canary for the tech sector, and the word is that the outlook continues to deteriorate, now including Europe and Asia, in addition to the US.
We continue to stress that what happens in the consumer cyclical and tech sectors is a good proxy for where earnings and the economy are headed. It would seem that the companies to particularly watch may be those in autos, homebuilding, and electronic distributors, and to keep sounding out analyst thinking in those industries.
It still looks like the final numbers for 2Q01 S&P500 earnings growth will be a decline of 11% to 13%. The analysts’ estimate currently stands at an 11.9% decline. It will go lower between now and July and then the actual results will beat the final estimates by a few percentage points. The 3Q01 estimate is a decline of 3.1%, but we believe the final results will be similar to the final 2Q01 results.
The key is 4Q01. Expectations are at a gain of 8.7%, but the comparison to the year ago quarter gets considerably easier in 4Q01. There is not enough visibility yet on 4Q01 to make a call on what the final results are likely to be. Until that visibility appears, the market remains vulnerable to further volatility, especially considering current valuations.
The First Call valuation model (comparing the forward four quarter P/E ratio to the inverse of the interest rate on the 10-year Treasury) indicates the market was about fairly valued on 30 March. However, the April and May surge in stock prices, particularly in the technology sector, along with the continued slippage in earnings forecasts, again particularly in the tech sector, pushed the P/E ratio to 23.6, compared to the implied fair market P/E of 18.4. That means the market is 28% overvalued, up 7 percentage points from last week.
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