FIRST CALL
Charles L. Hill Director of Research 617-856-2459
Thomas D. O’Keefe Research Analyst 617-856-2055
29 June 2001
THIS WEEK IN EARNINGS
2-6 July 2001
OVERVIEW
The first week of any quarter is usually a very slow week for earnings reports, but with a holiday in the middle of the week and a short day on Tuesday, many will be spending part or all of the week at the beach or the equivalent. As a result, there is almost nothing for earnings reports. For the same reasons, it is an extremely slow week for meetings and conferences.
We do get a slight taste of 2Q01 earnings announcements for companies with a June ending quarter. Alcoa and SunTrust Banks report on Friday. Economic sensitive companies reporting this week, in addition to Alcoa, include Roadway and Atlas Air on Tuesday and Ninety Nine Cent Only on Thursday.
Probably more important on the consumer front are the June sales reports from the auto makers on Tuesday, and on various days this week and next, June orders from homebuilders, June airline passenger miles, and June same store retail sales.
It is a very big week for economic news in regard to consumer spending. Monday brings May consumer spending & personal income, last week’s unemployment claims on Thursday, and the June employment report on Friday.
Other economic news includes May construction spending and the Jun purchasing managers index on Monday, May manufacturing orders on Tuesday, and the Jun non-manufacturing purchasing managers index on Thursday.
As the UN winds down its discussion on sanctions on Iraq, OPEC plans to hold an emergency meeting on 3 July. Given that prices have backed off rather than gone up since Iraq stopped shipping, OPEC likely will not increase production.
MARKET EARNINGS
It’s another pre-announcement blizzard, this time in June and early July. The market was buried in a blizzard of negative pre-announcements in January and in March and early April. Warnings ended at a record level in 4Q00, only to be broken in 1Q01 by 18%.
Last week, this week, and maybe next week will be the peak weeks for 2Q01 pre-announcements. Warnings for 2Q01 are currently running 6% below the 1Q01 pace at the equivalent point in 1Q01. A 6% difference is small enough that it could just be the noise in the data. Therefore, the final total for 2Q01 warnings likely will be best characterized as coming in at about the same as the 1Q01 record level.
If there is a silver lining in the earnings pre-announcement storm, it is that the rate of warnings is no longer rising and may be at least stabilizing. But don’t get too excited. The apparent stabilization is at a very high level. The negative pre-announcements for 2Q01 are running more than three times the rate in 2Q00 at the same point in that quarter.
Typically, the market tends to overreact on the negative side during the peak weeks of pre-announcements and overreact during the peak weeks of the actual earnings reporting season. The market seems to forget that there is always a negative bias to pre-announcements and always a positive bias the reports of the actual earnings. The germane question for the respective periods is "Are the pre-announcements more or less negative than usual?" and "Are the actual earnings more or less positive than normal?". But the market seems to ignore those questions and react the same every quarter regardless of the answer to those two questions.
Given the current pace of negative pre-announcements, a negative market reaction seems justified. It remains to be seen how the earnings reports come in relative to expectations, but it is doubtful that the results will beat the estimates by more than normal, so the usual euphoria that "earnings are coming in above the estimates" may again not be justified this quarter, just as it proved to be premature when 4Q00 and 1Q01 results came out.
Clearly the market in recent months has been discounting poor earnings results for 2Q01, and clearly the earnings will be poor. Based on the industry analysts’ consensus estimates for each of the companies in the S&P500, 2Q01 earnings are expected to be down 17.4% from 2Q00. That expectation may erode a little further this week and maybe next week, but as the actual results start coming in and are included in the data, the 2Q01 expectations should rise. The final results (remember most of the companies with a July ending quarter will not report until August, with a few spilling into September) likely will show a decline of about 15%. (However, about 1.5 percentage points of the decline come from analysts including the costs of the Ford recall and about 0.6 percentage points come from analysts including a major inventory writedown at Nortel)
So far, 31 companies (all companies with a May ending quarter) of the S&P500 companies have reported 2Q01 earnings. That is only 6% of the 500. It is far too early to garner any useful info from the data. That will probably continue to be the case until the week of 16 July.
Current estimates for 3Q01 S&P500 earnings are at a decline of 6.0%. At the beginning of this year, the analysts were expecting a gain of 9.2%. By 1 April, the beginning of 2Q01, the expected gain had slipped to 1.6%. By 1 June, The gain had shifted to an expected decline of 3.4%. In the month since then the estimate has been further cut to the current 6.1% decline. That means the monthly rate of decline has not slowed. Given the current momentum in earnings warnings and downward estimate revisions, 3Q01 estimates are likely to be cut significantly between now and the October reporting period. If 3Q01 expectations decline at the same rate as they did in the prior three months, that would imply final results of a 13.8% decline. Final results could be similar to those of 2Q01, particularly if the 2Q01 results excluded the Ford recall and Nortel inventory write down.
Assuming there is no substantive earnings recovery in 3Q01, the key to the market is whether a substantive earnings recovery will occur in 4Q01. Most of the investment community appears to be expecting a 4Q01 recovery. As of 1 April, expectations for 4Q01 were at a 12.6% gain, by 1 June that had dropped to 8.1%, and more recent cuts have taken the expected gain to 5.7%. As with the estimates for 2Q01 and 3Q01, the reductions in June for the 4Q01 estimate was cut at about the same monthly rate as in April and May. If warnings and downward revisions slow to a more normal pace before year end, the best that would be attainable would be a gain of about 2% over the weak 4Q00.
However, the more likely scenario is that 4Q01 earnings will be down slightly from the weak 4Q00. The other "however" is that 4Q01 earnings could be down much more than a few percent. There is not yet enough visibility to confirm that 4Q01 earnings will show the meaningful improvement that the market is currently discounting.
That meaningful improvement is dependent on whether the consumer will keep spending at the surprising rate of recent months. The 4Q01 improvement the analysts are currently expecting in S&P500 earnings will get no help from technology or energy. Energy sector earnings are expected to be down 20% in 4Q01, while the tech sector earnings are expected to show a decline of 24%, even though tech has an easier comparison in 4Q01 than it did in the three earlier quarters. Rather, the 4Q01 earnings improvement is driven by the analysts expected year-over-year earnings gains of 17% in the consumer cyclical, 18% in the consumer staples, and 25% in the financial sectors.
Therefore, the key to the 4Q01 earnings recovery, and thereby for the stock market recovery is whether the consumer will keep on spending despite being buffeted by the continuing high pace of layoffs. We cannot emphasize enough that what will make or break the earnings recovery beginning as soon as 4Q01 is consumer spending. The focus over the next month should be on the economic and company news that provides info on what the consumer is likely to do over the next six months. Forget all the bad headlines on tech. That will not be new news.
Now that the year is half over, it is time to turn attention to the estimates for the calendar 2002 year. The issue is whether they are realistic in view of the increasing downward trend in sequential quarter earnings in 2001. Seasonally adjusted sequential quarterly earnings have shown a decline in 1Q01 and 2Q01, and likely will in 3Q01. If the there is no earnings improvement in 4Q01 over 3Q01 or only a very modest one, than there will have to be some sequential quarterly earnings growth on a seasonally adjusted basis in each quarter of 2001 just to bring earnings back up to the full year number of 2001.
So far, analysts have been bringing their 2002 estimates down slightly less than they are bringing down their 2001 estimates. As a result the percent earnings growth expected for 2002 has actually risen slightly since the beginning of the year. The current 19.1% expectation may prove unattainable if 4Q01 earnings are disappointing.
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.
The S&P500 was at $1227 and the 10 year note interest rate at 5.40%. Forward 4Q earnings through 2Q02 for the S&P500 earnings are at $53.09. (Same period earnings normalized to the 7.29% trend line of the last 33 years would be $54.92, so forecasted earnings are only 3% below normalized). The current P/E is 23.1, compared to the implied fair market P/E of 18.5. That means the market is 25% overvalued, up 4 percentage points from last week but down 6 over the last five weeks.
The Congressional subcommittee hearings in June, on analyst bias, is probably just the tip of the iceberg of what is to come. Although Chairman Baker and other subcommittee members applauded SIA addressing the problem with a Best Practices paper, it was made very clear that more was needed, particularly in regard to enforcement provisions by the industry. The SEC joined the cause last week by putting out an investor alert. It warned investors about the analyst bias in recommendations and suggested that investors consult other objective research rather than exclusively using reports from analysts with investment banking firms.
There will surely be more subcommittee hearings or roundtables on this subject. While this forthcoming stream of negative news may not hurt the market, it certainly will not help it.
The SEC’s Regulation Fair Disclosure seems to be working at least as well as was expected at this early stage. In addition to leveling the playing field for individual investors and small institutional investors in having access to company info, there are some indications that it may lead to sell side analysts doing better fundamental analysis with less of a short term orientation.
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