MARKET EARNINGS
Some months back, we asked if you could say "free fall". Now we are asking if you can say "recession". Mr. Greenspan, as a public servant, does not want to add fuel to the fire by saying "recession", but even he must believe that we are now in one. S&P500 earnings will be down from the year ago period for 1Q01 and 2Q01, and very likely for 3Q01 and CY01.
Making the call back then that the earnings downturn was going to be steeper and longer than most were expecting, and that technology was going to be the big problem, was an easy one. The tougher call continues to be when and how deep the bottom will be.
It is next to impossible to predict where the bottom in earnings will be when company guidance and analyst estimates are falling at such a rapid pace. All one can do as the downturn unfolds is check off quarters that will not be the bottom. Recent thinking is that the bottom would be 2Q01, but we now believe it will be 3Q01 at the earliest. As companies and analysts keep cutting expectations and pushing out the recovery, the realization has set in that their earlier optimism was misplaced. They simply do not know when the recovery is likely to start. Hence, the emergence of "no visibility" as the current buzzword.
At the moment, the numbers indicate that the bottom in S&P500 year-over-year earnings growth would be as soon as 1Q01, but with 1Q01 estimates currently at a 4.3% decline and 2Q01 currently at a 2.2% decline, it is inevitable that the final numbers for 2Q01 will be lower than those of 1Q01. The real question has been whether the bottom will be 2Q01 or whether it will be 3Q01 or later. It now seems likely, with only a difference of 7.5 percentage points between the 2Q01 estimate of a 2.2% decline and the 3Q01 estimate of a 5.3% gain, that the bottom in earnings will not be until 3Q01 at the earliest.
Earnings estimates for S&P500 companies in the aggregate continue to be cut far more than normal for the first half of 2001. In the two months since 1 Jan, expectations for S&P500 year-over-year earnings growth have declined by 9.1 percentage points (from a 5.0% gain to a 4.1% decline) for 1Q01 and by 8.5 percentage points (from a 5.3% gain to a 2.2% decline) for 2Q01, and by 3.8 percentage points (from a 9.2% gain to a gain of 5.4%) for 3Q01.
Compared to the same period in the record setting 4Q00, negative pre-announcements for 1Q01 are running 59% higher, while the positive and on target ones are running 33% lower and 52% lower, respectively.
The main problem continues to be the technology sector. We hate to sound like a broken record, but we continue to believe tech is the key to this downturn, and will be the key to the upturn. Negative pre-announcements for 1Q01 in the technology sector are up 111% from the record setting 4Q01, compared to a 23% increase for the non-tech sectors. Tech earnings estimates continue in free fall for 1Q01, 2Q01, and 2Q01.
In the past two months, expectations for S&P500 tech sector year-over-year earnings growth have declined by 28 percentage points (from a 4% gain to a 24% decline) for 1Q01, by 23 percentage points (from a 2% gain to a 21% decline) for 2Q01, and by 19 percentage points (from an 11% gain to an 8% decline) for 3Q01. These changes follow the fall off from a 42% gain in 3Q00 to only a 3% gain in 4Q00.
There is no sign of a slowdown in the downward revisions for the tech sector. One would have expected to see the bulge in warnings and downward revisions that occurred during the period when companies were reporting their 4Q00 earnings. But it usually quiets down for a week weeks before starting to accelerate the last two or three weeks of the quarter as we near the reporting season. However, over the last two weeks, the tech earnings expectations for 1Q01, 2Q01, and 3Q01 have each been dropping almost a full percentage point each day.
We believe declines of this suddenness and severity since October indicate that the downturn in technology is not only reflective of a weakening economy, but also of a cyclical downturn within technology itself.
This downturn in technology is looking more and more like those of 1969-70, 1973-74, and 1979-1980. During those periods, a downturn induced by the transitions to new generations of IBM computers (the main driver in the technology sector) coincided with the economic downturns and exacerbated the impact of those economic downturns.
Technology advances do not come in a steady stream. The 1990's, especially the latter half, saw a surge in tech advances. That ultimately led to investment excesses. The purging of those excesses is a healthy and necessary development, but a painful one.
In addition to the direct impact of the lowered tech estimates on the aggregate estimates, the deepening weakness in the tech sector is beginning to add to the slowdown in other sectors. The tech sector has been the driving factor in the phenomenal economic expansion in the 1990's. In addition, the collapse in tech earnings has led to a collapse in NASDAQ prices. This in turn feeds back to lower consumer confidence and spending, which further exacerbates the downturn.
Despite the enthusiasm for the Fed rate cuts and congressional tax cuts, it is important to remember that the earliest they would impact earnings would be 4Q01, but more likely 1Q02. Earnings tops and bottoms tend to lag economic tops and bottoms by about one quarter. Therefore, we have already been dealt our hand for 3Q01. We just haven't seen all the cards yet. The Fed, with its January cuts, may have dealt us a new hand for 4Q01, but whether it is meaningfully better is not yet known.
A growing worry is the Japanese economy. The CPI number last week raises concern over a deflationary spiral in Japan. The Japanese stock market hit a 15 year low last week. With the Nikkei now just above 12,000, there is a danger that the market could end the March fiscal year at a level low enough to trigger problems for the Japanese banks. Although they have sold off some of their extensive stock holdings, there is still a large amount held. Those holdings get counted as part of the banks required capital, but they must be revalued at the end of the fiscal year. Those valuations might come in low enough to put some banks into capital requirements problems, putting further strains on the Japanese financial system and economy.
Japan is the world's second largest economy and its economy has been meandering for a decade. If a banking crisis should emerge, it could destabilize the Japanese economy, already probably in recession, and cause problems for the world economy. That scenario is probably a long shot, but one that should not be ignored.
Despite all the present concerns, it should be remembered that these problems are cyclical and will pass. Technology will remain the growth engine, but with considerable cyclicality superimposed on a high growth trend line. Unfortunately, too many had come to believe that technology was no longer cyclical. As Yogi said, "déjà vu all over again". Those who were around in the 1970's will remember that similar arguments were advanced prior to each recession that occurred in that period.
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