MARKET EARNINGS
During the next four weeks, there will be a steady stream of financial information from companies, in addition to a Fed meeting this week and the usual economic data. This week and the next one or two will be the peak weeks for pre-announcements. The third and fourth weeks will be dominated by reports from the companies. The most important information will be the comments and earnings guidance relating to 3Q01 and 4Q01.
The market is already discounting dismal earnings for 3Q01, but is counting on a substantive S&P500 earnings recovery in 4Q01. The expected 4Q01 earnings recovery is based on strong year-over-year earnings gains in three of the eleven S&P500 sectors. The consumer cyclicals are expected to be up 17%, consumer staples up 19%, and financials up 26%. Therefore, the key to the 4Q01 is continued spending by the consumer.
There will be no help in 4Q01 from the technology sector. Even with moving to an easier comparison in 4Q01 to the year ago quarter, tech 4Q01 earnings are already expected to be down 23% and that expectation continues to drop at a rapid rate. Energy, which has been the brightest sector in the last few quarters, is expected to be a drag in 4Q01. Tougher comparisons, coupled with decreases in oil and natural gas prices, have led analysts to expect a 20% decline in 4Q01 energy sector earnings.
Analyst expectations for 4Q01 dropped from 7.1% to 6.2% last week. That 0.9 percentage point drop was much greater than in prior weeks. Continuation of downward revisions at that rate would mean final results would show a year-over-year decline of about 15%.
Whether that decline was an aberration or the start of a trend of slashing 4Q01 estimates will depend on consumer spending. Therefore, the wheat in all the financial news chaff coming out over the next four weeks will be the comments and guidance from companies in the consumer cyclical and consumer staple sectors. The media may pay more attention to warnings from Nortel or Merck, but the ones to watch are those from the consumer companies. Recent warnings from Maytag, Kenneth Cole Productions, and Pier 1 Imports are of greater concern. So far, the warnings from the consumer companies have not reached an alarming rate, but if it should, that would be very ominous.
It seems highly likely that the news from the tech sector will remain very negative in the near term. In the tech sector, the canaries in the coal mine are the electronic component distributors and the contract manufacturers. They serve a broad spectrum of the technology sector, and are not as dependent on company specific problems as the individual companies might be. When these canaries are singing, it usually means the entire sector has major problems. Last week, Avnet, Solectron, Jabil Circuit, and Sanmina made a chorus. More warnings from the tech sector are likely to follow over the next few weeks.
Analysts continue to slash tech sector estimates. Last week, the 2Q01 tech earnings decline estimate was cut from 60% to 64%, the 3Q01 estimated decline from 44% to 48%, and the 4Q01 estimated decline from 19% to 23%. That, along with some help from the transport sector, brought the overall S&P500 earnings decline estimate for 2Q01 down 16.1% to 17.2%, the 3Q01 decline down from 4.4% to 5.5%, and the 4Q01 growth down from 7.1% to 6.2%.
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, 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 and has remained there. The S&P500 was essentially flat in May, but earnings continued to slide while the interest rate on the 10 year note rose. Since the beginning of June, the market has backed off some. The current P/E is 23.3, compared to the implied fair market P/E of 19.3. That means the market is 21% overvalued, up 3 percentage points from last week and down 11 over the last four weeks.
Now, some investors might say that since the earnings part of the P/E is based on earnings that are depressed from recent levels, and therefore, one can justify a higher P/E. We believe that is shaky ground. Even though earnings will be down from last year, they are only down to $53.33. That is only 3% below the $54.92 earnings on the 7.29% trendline for the S&P500 over the last 33 years.
That means that, at least so far, earnings have not dropped as far below, or for as long below, the earnings trendline as in prior downturns. Furthermore, the current earnings estimate for 2002 of $59.82 puts earnings back above trendline. Trendline earnings for 2002 would be $57.90, meaning the current estimated earnings for 2002 would be 3% above the trendline earnings.
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