MARKET EARNINGS
With the negative psychological impact of the peak weeks of the earnings confessional season now behind us, the viewing of the investment glass shifts from half empty to half full. During this week and next the steady stream of earnings reports, most of which will beat the estimates, will have a positive psychological impact. That will be true even if the number of the companies beating the estimates and the amount they beat estimates by are both less than the average over the last six years.
The market should be sophisticated enough to understand that the pre-announcement season always has a negative tilt and that the reporting season always has a positive tilt, and, therefore, the results of each period should be judged by whether they are better or worse than the norm. But since the market normally does not, merely beating the estimates by any amount (as we always do!) will get investors talking about how the earnings outlook is improving.
The positive pre-announcement last week from Microsoft may have been the kick-off for the traditional summer rally in stock prices. Given the steady stream of bad news from technology companies in recent weeks, the Microsoft news was a welcome respite. However, Microsoft’s good news may not rub off on many of the other technology companies. Even before the economic slowdown, analysts were forecasting earnings growth for this period slowing at Microsoft due to the product transition to a new Windows generation. For Microsoft this product transition is having more impact on their earnings than is the cyclical slowdown in the sector. Therefore, the good news at Microsoft may be limited to itself and perhaps a few other software companies tied to the Windows product line. Nevertheless, Microsoft has given the market a psychological boost.
The stage may be set for a summer rally, but whether it is nothing more than that, rather than the start of a bull market remains to be seen. Beating the final 2Q01 estimates may pump up the market for a while, but a sustained rally is dependent on achieving some reasonable visibility as to when the bottom in the economy and earnings is likely to occur and how deep it may be. That visibility still seems to be lacking.
We continue to believe that any recovery in the economy and in earnings will be driven by consumer spending. The retailers’ sluggish same store sales in May and again in June remain a concern. Many of the retailers reported a decline in June same store sales from last year and/or came in short of the downward revised expectations for June.
The retailers that have already warned in July of an earnings shortfall include Federated Department Stores, Tiffany, TJX, AnnTaylor, Ross Stores, Kohl’s, Guess?, Men’s Wearhouse, Wilson’s Leather Experts, Stein Mart, Toys R Us, Linens ‘n Things, Gadzooks, Gymboree, Children’s Place, Brown Shoe, Factory 2-U Stores, Guitar Centers, Sharper Image, Goody’s, Wet Seal, and Longs Drug Store. Several others fell short enough on same store sales to trigger analysts lowering their estimates, even though the company did not issue an earnings warning. What strength there is in retailing appears to be confined to the discounters.
Despite the prospects of a summer rally, 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. It now appears likely that there will be no substantive recovery until at least 1Q01. At present the industry analysts are expecting S&P500 2Q01 earnings to decline 18.0%, but as the actual results come in this week, that number will climb. The final results will likely show a decline of about 15%.
Warnings for 2Q01 continue to run close to the record setting pace of 1Q01. At the end of last week, there had been 805 warnings for 2Q01, compared to 866 for 1Q01 at the equivalent point in 1Q01. The 805 is 7% below the 1Q01 rate, but more than three times the 256 in 2Q00. With this kind of momentum in warnings, it is highly probable that warnings will continue at a well above normal pace in 3Q01. That will trigger further slashing of the 3Q01 estimates. Last week the 3Q01 expectations dropped from a 6.7% decline to a 7.5% decline. The week before they dropped from a 6.1% decline to one of 6.7%. That puts the average weekly decline over the last two weeks at 0.7 percentage points. The average weekly decline in June was 0.6 percentage points. It would appear 3Q01 earnings will likely be down almost as much as 2Q01 earnings will be.
Even more ominous last week was that expectations for 4Q01 dropped 1.1 percentage points from 4.8% growth to 3.7% growth. That followed a decline of 0.7 percentage points the week before, and an average weekly decline of 0.6 percentage points in June. Final results will surely show a decline from 4Q00, even though the comparison to the year ago quarter gets easier in 4Q01. The differential in year-over-year earnings growth for 4Q01 over that for 3Q01 is likely to be no more than a dozen percentage points. That would probably mean that, seasonally adjusted, 4Q01 earnings would be lower than those of 3Q01.
It appears that beating the 2Q01 final estimates will generate a summer rally (irrespective of 2Q01 estimates being revised down from a 6.3% decline at the beginning of the quarter to an 18.0% decline by the start of the reporting season). But the increasing realization that no meaningful recovery in earnings is likely to occur before 1Q01, and that not even that is assured, may make the rally short-lived.
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 $1216 and the 10 year note interest rate at 5.25%. Forward 4Q earnings through 2Q02 for the S&P500 earnings are at $54.93. (Same period earnings normalized to the 7.29% trend line of the last 33 years would be $55.92, so forecasted earnings are only 2% below normalized). The current P/E is 22.1, compared to the implied fair market P/E of 19.0. That means the market is 16% overvalued, down only 1 percentage points from last week but down 15 over the last seven weeks.
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