And Now Back To Reality And The Impossible Earnings Season Stepfunction
Last week the S&P erased 6 days of consecutive losses in 30 minutes of trading on the back of news that JPMorgan lost at least 25% of its average annual Net Income in one epic trade, and stands to make far fewer profits in the future, even as the regulators are about to fire a whole lot of traders for mismarking hundreds of billions in CDS. This was somehow considered "good news." This being the "new normal" market, where nothing makes sense, and where EUR repatriation as a result of wholesale asset sales by European banks drives stocks higher, we were not too surprised. Sadly, even in the new normal, things eventually have to get back to normal. And that normal will come as corporate earnings are disclosed over not so much over the next 3 weeks, when 77% of the companies in the S&P report Q2 results, but in the 3rd quarter. Why the third quarter? Simple: as Goldman's David Kostin explains, "consensus now expects year/year EPS growth to accelerate from 0% in 2Q, to 3% in 3Q to 17% in 4Q." Sorry, but this is not going to happen, and as more and more companies preannounce on the back of the global slowdown which many has seeing US GDP down to 1.3% in Q2, and sliding further in Q3 absent some massive QE program out of the Fed, it is virtually guaranteed that the unchanged Earnings precedent that Q2 will set (and there is a very high probability that Q2 2012 will mark the first YoY drop in earnings since the unwind Great Financial Crisis) will continue into Q3 and likely Q4. Because, sadly there simply is no catalyst that will drive revenues higher, even as margin contraction was already set in.
All of this also means that the only possible driver of S&P growth in Q3 (of which we are already 2 weeks deep into) and Q4 will be multiple expansion. This, however too, will be a disappointment. Again from Kostin:
We believe P/E multiple expansion is unlikely in 2H. Headwinds include the fast-approaching Presidential election, associated policy uncertainty, and the looming “fiscal cliff” that everyone outside the beltway decries but no one in Washington, DC seems willing to seriously address.
Not to mention the debt ceiling which is still on track from making US landfall sometime in the next 3 months.
So while short covering rallies are fast and furious, corporations -that traditional deus ex to justify US "decoupling" - now have only one fate before them: disappointment.
Which leaves the Fed. Sadly, not even the extension of Twist can do anything about the biggest concern that banks are currently facing, namely the accelerated decline in reserves, as a result of the prepayment of Maiden Lane obligations and the gradual drop in FX swaps (at least until the next time Europe needs a Fed-based bail out that is). As can be seen in the chart below, Adjusted Reserves have tumbled to level not seen since December, and then May of 2011, both times when the market was about to turn over if not for global coordinated central bank intervention.
Full note from Goldman:
Our 2012 investment thesis for the US equity market has three pillars: a stagnating economy, static P/E multiple, and minimal earnings growth.
First, weak macro data and three proprietary Goldman Sachs indictors support our view of a lackluster economy. The Goldman Sachs Current Activity Indicator (CAI) shows the US economy growing at an annualized pace of just 1.3%. The three-month moving average of our Earnings Revision Leading Indicator (ERLI) diffusion index, a measure of 29 separate micro-driven industry data points, remains below trend at 41, consistent with a softening of our Global Leading Indicator (GLI). On the macro front, the June ISM report slipped to 49.7, the first sub-50 print in three years.
Second, we believe P/E multiple expansion is unlikely in 2H. Headwinds include the fast-approaching Presidential election, associated policy uncertainty, and the looming “fiscal cliff” that everyone outside the beltway decries but no one in Washington, DC seems willing to seriously address.
The third leg of our three part framework will come into clarity during the next several weeks as firms report 2Q results and offer guidance on business activity for the second-half of 2012. 80% of S&P 500 market cap will report between July 16th and August 3rd. Firms to watch next week include: BAC, C, GE, IBM, JNJ, KO, MSFT, PM, SLB, and VZ.
We expect a modest quarterly earnings miss. A shortfall in sales rather than margins will be the primary culprit. Firms will struggle to meet revenue forecasts given weak global demand and a strong US Dollar. Consensus margin expectations are already flat or negative in most sectors.
Bottom-up consensus currently forecasts flat year/year EPS growth, driven by a 4% increase in sales and a 40 bp fall in margins to 8.9%.
Five sectors are expected to post negative earnings growth in 2Q 2012 compared with 2Q 2011: Energy, Materials, Utilities, Consumer Discretionary and Consumer Staples. Analysts forecast Materials and Energy will both post year/year EPS declines of 12% reflecting the sharp fall in commodity prices during 2Q, with Brent plunging by 16% and copper dropping by 10%. In contrast, Industrials and Information Technology will report EPS growth of 7% and 11%, respectively. Apple (AAPL) will again be a standout performer with year/year sales and EPS growth of 32% and stable margins of 25.6%. Including AAPL, the Tech sector is forecast to deliver sales and EPS growth of 9% and 11%, respectively. Without AAPL, the sector will post revenue and EPS growth of 6% and 7%, respectively.
2Q results will affect the market’s outlook for earnings in 2012 and 2013. Consensus now expects year/year EPS growth to accelerate from 0% in 2Q, to 3% in 3Q to 17% in 4Q. Consensus forecasts full-year EPS growth will double from 7% in 2012 to 14% in 2013. In contrast, we do not forecast a steep 4Q 2012 inflection and anticipate EPS growth climbing from 3% in 2012 to 7% in 2013.
Our full-year 2012 and 2013 S&P 500 EPS forecasts remain $100 and $106. Current bottom-up consensus equals $103 and $117. Consensus 2012 estimate has dropped from $107 in January and from $114 in August 2011.
Earnings season focus points: (1) domestic demand; (2) international weakness; (3) margins; and (4) losses from JP Morgan’s CIO unit.
Our ERLI Diffusion Index suggests US micro data improved in June but the three-month moving average remains below trend at 41. In May, our diffusion index of micro driven, industry-level data points fell to 29, the lowest reading since April 2009 (a reading of 50 implies “trend” growth). However, data rebounded in June producing a slightly above trend reading of 53, with 23 of 29 industry variables increasing at a trend or better pace. Examples include hotel occupancy, rail car loadings, and NY/NJ port activity. If this trend persists, it implies that the micro data points which inform equity analysts’ earnings projections may not be as poor on a near-term basis as an otherwise gloomy macro picture suggests. In contrast, our macro driven Global Leading Indicator of industrial production has been contracting at an accelerating rate for the last three months, which our research has shown augurs poorly for S&P 500 returns.
Margins will once again be source of scrutiny. Margins have stabilized at 8.9% for more than a year after having surged by 300 bp from a cyclical low of 5.9% in 2009. Differing margin forecasts explain 80% of the gap between our top-down EPS estimate and bottom-up consensus for 2012. Consensus expects margins to remain flat during the first three quarters of 2012 before rising sharply starting in 4Q and expanding to 10% by year end 2013. In contrast, we forecast margins will hover around 8.9% for the next two years.
JP Morgan CIO trading losses. This morning JPM reported 2Q EPS of $1.21, 59% above consensus expectations of $0.76. Of course, analysts had cut estimates by 38% since May after the bank disclosed large trading losses in its chief investment office. The JPM CIO losses of $4.4bn reduce 2Q 2012 EPS for the S&P 500 by $0.49. For the Financials sector, year/year EPS growth in 2Q is anticipated to be 8% including JPM and 12% without.