MARKET EARNINGS
Even though the peak weeks of the 2Q01 reporting season were over before last week, the warnings and the downward revisions in earnings estimates to continue to pour in. With 35% of the S&P500 companies reporting the week of 16 July and another 33% the week of 23 July, it was not surprising to see considerable activity in warnings and revisions. Last week only 9% of the S&P500 companies reported, but 3Q01 warnings continued to hover around a record level pace and earnings estimates for 3Q01, 4Q01, and 1Q02 continued to spiral downward.
Warnings for 3Q01 rose last week from 218 to 271. They continued to run well ahead of the record setting pace of 1Q01, and are only slightly below the 2Q01 pace. The 2Q01 started out with a bang, but is ending up about 6% below the 1Q01 record. It is not yet clear whether the 3Q01 warnings will set a new record, or fall slightly short of a record as 2Q01 warnings are doing. Given the continuing stream of warnings in recent weeks, it is likely the final number for 3Q01 will at least be close to a record and will certainly be well above normal. The 271 compares to only 36 at the equivalent point in the fairly normal 2Q00 quarter.
This debilitating stream of warnings is fueling the continuing slashing of near term estimates. Since 1 July, the beginning of 3Q01, the expected decline for S&P500 earnings has dropped from 6.2% to 12.4%. Last week the drop was 0.9 percentage point. During the same time span, the gain expected for 4Q01 dropped from 5.5% to 0.0%. The drop last week was also 0.9 percentage point. And 1Q02 is no longer immune. The drop in the expected gain during the period was from 13.4% to 10.1%. Last week the fall was 0.8 percentage point.
A new and growing problem for earnings for the next three quarters is that analysts are aggressively cutting estimates in the energy sector. The analysts had aggressively and continuously raised energy sector estimates for each of the last five quarters. In the five weeks since 1 July, the expectations for energy sector earnings DECLINES have fallen from 8% to 17% for 3Q01, from 21% to 26% for 4Q01, and from 17% to 23% for 1Q02.
After being the sector with the biggest positive effect on S&P500 earnings in the last three quarters, energy will be a drag on S&P500 earnings. Starting with 3Q01 and continuing well into 2002, energy sector year-over-year earnings comparisons shift from growth to decline. The 17% decline now expected for 3Q01 is even deeper than the 12% decline expected for the overall S&P500.
The free fall in technology earnings continues, although not as rapidly as in the last few weeks. The downward revisions last week for 3Q01, 4Q01, and 1Q02 were 2 percentage points for each. That follows total declines for the last four weeks of 14, 11, and 17 percentage points, respectively.
The same pattern exists in basic materials sector (papers, metals, and chemicals). Last week’s downward revisions were 3, 2, and 4 percentage points for 3Q01, 4Q01, and 1Q02, respectively. That follows total declines for the last four weeks of 14, 13, and 14 percentage points, respectively.
The most disturbing aspect of the continuing free fall is the degree to which it has now spread to 1Q02. Estimates for these two sectors were the first to be cut for 3Q01 and then 4Q01. In both those cases it later spread to several other sectors. In addition to the slashing of tech and basic materials estimates, 1Q02 aggregate estimates are being dragged down by the slashing of energy sector estimates.
The real issue for 1Q02 earnings continues to be whether the earnings growth rebound expected in the consumer cyclicals and consumer staples sectors can more than offset the softness that appear to be in the cards for the technology, energy, and capital goods sectors earnings in 1Q02. Earnings for the consumer cyclical sector are expected to be up 30% in 1Q02, following an expected 16% gain in 4Q01. Both quarters benefit from easy comparisons to year ago periods. The consumer staple sector is expected to be up 16% in 1Q02, following an expected 17% gain in 4Q01.
The timing and strength of the earnings recovery will be driven by consumer spending. Therefore, it will be the earnings from the consumer cyclical and consumer staple sectors that will make or break whether the aggregate numbers begin to show improvement. Even allowing for the easier comparisons, the expectations for those two sectors in 4Q01 and 1Q02 are possible, but are an ambitious target.
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 1 April, the beginning of this quarter. However, the April surge in stock prices, particularly in the technology sector, along with the continued slippage in earnings forecasts, again particularly in the tech sector, led to the market moving solidly back into overvalued territory. It has remained in overvalued territory since than.
At the end of last week, the S&P500 was at $1214 (about the same as the $1206 last week) and the 10 year note interest rate at 5.16% (about the same as the 5.10% last week). Forward 4Q earnings through 2Q02 for the S&P500 earnings are at $53.71 (down 1% from last week’s $53.99). (Same period earnings normalized to the 7.29% trend line of the last 33 years would be $55.92, so forecasted earnings are only 4% below normalized). The current P/E is 22.6, compared to the implied fair market P/E of 19.4. That means the market is 16% overvalued, up two percentage points from last week but down 9 over the last nine weeks.
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