MARKET EARNINGS
The pace of pre-announcements was tempered because of the mid-week holiday. Compounding the day off was the half day for the market on Tuesday. In addition, there were essentially no companies meeting with the financial community. Upcoming appearances often trigger a pre-announcement (although most of those tend to be on-target pre-announcements). The net result may be that some pre-announcements that ordinarily might have happened last week have been pushed into this week. Stay tuned.
The summer blizzard in overall negative pre-announcements continues. Holiday or not, the peak weeks are usually the last week of the quarter and the first two after the quarter ends. Therefore, the blizzard continues this week. (Apparently, the 4 July holiday was merely the eye of the storm.) Warnings for 2Q01 are currently running 11% below the 1Q01 pace at the equivalent point in 1Q01. A 10% difference is small enough that it could just be the noise in the data (particularly since there was a holiday last week but none in the comparable week for 1Q01 pre-announcements, and since there is no holiday this week, but there was in the comparable week for 1Q01 pre-announcements). Therefore, the final total for 2Q01 warnings likely will be best characterized as coming in at about the same as the 1Q01 record level.
As we said last week, 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.
The warnings from the tech companies continue to get most of the media attention. While it has been no surprise to see the steady stream of tech warnings, it was a bit of a surprise to see the magnitude of the shortfall at EMC, Advanced Micro Devices, BMC Software, and Marconi. Warnings of that size mean either the company didn’t have good enough internal controls to know sooner, or business fell off sharply at the end of the quarter. It appears the prime reason was the latter, implying that tech earnings going forward may be much worse than already expected, and the recovery may be even further off.
But the warnings deserving the most attention are not the continuing stream from the tech companies. Going forward, any near term earnings recovery in the US is almost solely dependent on the US consumer continuing to spend at the better than expected rate of recent months. Despite all the attention directed at the tech warnings, we believe the warnings, or lack thereof, from the consumer cyclical and consumer staples sectors are of greater impact.
Although the pace of warnings from those sectors has been tolerable so far for 2Q01, the warnings last week from Federated Dept Stores was ominous, and to a lesser degree, those from Stein Mart and Long’s Drug Store. The retailers are particularly vulnerable this week and the 6 August week. Many retailers report same store sales for June and July, respectively, on Thursday of those two weeks.
Recent economic and company data appears on balance to confirm that the consumer continues to spend. The auto unit sales for June were in line or maybe a little better than expected. Homebuilding orders for June continue to show surprising strength. The potential weak link is retailing. Was the Federated Dept Stores warning of last week an anomaly or was it the tip of the iceberg? The Federated warning was disturbing not only because of the magnitude of the shortfall, but because Federated felt compelled not to wait until this Thursday when it and many of the other retailers will report June same store sales and have to publicly comment about business conditions. Will others warn this Thursday?
Even if there is no rash of retailer warnings on Thursday, will the same store sales reports be lackluster enough to engender a stream of downward revisions in earnings estimates for retailers. Better be in the office on Thursday.
As of last Friday, the industry analysts were expecting S&P500 earnings to decline 17.6% in 2Q01. That estimate will likely slip to 18% this week. As the earnings report tide comes in next week with the actual results, the number will climb to a decline of about 15%. Even though warnings and downward estimate revisions may slow in 3Q01, there is enough to momentum that earnings will likely be slashed from the current expectation of a 6.7% decline to a decline similar to that of 2Q01.
Although there is still a chance the consumer may continue to spend at a strong enough rate to drive an overall earnings recovery in 4Q01, that recovery at best will only be a modest one over 2Q01 and 3Q01. Even though the year-over-year comparison gets much easier in 4Q01, the expected growth has been cut to a gain of only 4.8% (It was at 16.9% on 1 Jan and at 7.9% on 1 Jun). The best that can be expected for the final results is a decline of 1% or 2%, but the decline could be much greater. But even a decline of 1% or 2% compared to a probable 15% decline in 2Q01 and 3Q01, would not represent much if any of a sequential quarter improvement in earnings from 3Q01 to 4Q01 on a seasonally adjusted basis. Because of the degree earnings growth fell off in 4Q00 from 3Q00, one cannot rely on year-over-year earnings growth as a proxy for seasonally adjusted sequential quarter growth. But if 4Q01 year over year growth is only marginally better than that for 3Q01, than 4Q01 earnings were probably down from 3Q01 on a seasonally adjusted basis.
Even if there is an earnings recovery in 4Q01, it could prove to be a false start if the European and Japanese economies continue to decline at a rapid pace. The US consumer may provide a lift to the US economy by 4Q01, but if the overseas economic slowdown leads to a decline in US exports, the resultant layoffs could ultimately break consumer confidence. That could cause the consumer to cut back spending, leading to another leg down in the economy and in earnings.
We continue to believe a cautious stance in the market is prudent until there is better visibility on when earnings may be reasonably expected to bottom.
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 $1189 and the 10 year note interest rate at 5.37%. Forward 4Q earnings through 3Q02 for the S&P500 earnings are at $55.36. (Same period earnings normalized to the 7.29% trend line of the last 33 years would be $55.92, so forecasted earnings are only 1% below normalized). The current P/E is 21.5, compared to the implied fair market P/E of 18.5. That means the market is 17% overvalued, down 8 percentage points from last week (partly because of the lower price and partly shifting the forward 4Q earnings from but down 14 over the last six weeks.
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