22% of the Q1 earnings season (by market cap) is over, and anyone listening merely to soundbites and reading media headlines would likely think that stocks have soared as a result of a relentless parade of beats. One would be mistaken. In fact, as the chart below shows, there is something very wrong with this earnings season...
Well isn't that special: the average return of all companies beating both the top and the bottom line three days after the report is... down 1.2% (less odd is that companies missing the top line are getting trounced more than double to the downside, or down 2.6% at T+3 on average)? Is there more to this earnings season that meets the eye? It would appear so. Morgan Stanley explains:
With 22% of the S&P 500’s market cap reported, earnings results are mixed. Aggregate earnings are tracking 5.9% ahead of consensus expectations driven by a combination of cyclical growth (AA and AXP), structural improvement (JPM), and tax related gains (IBM), whereas revenue (ex Financials) is pacing modestly above estimates at 0.6%. Yet, the financials sector (18 companies reported thus far) has contributed over 40% of the earnings beat, while GOOG, IBM, and ORCL alone have contributed an additional 17%. The remaining 57 reported companies have accounted for less than 40% of the upside (Exhibit 2 – sidebar right). So far during this earnings season, BBY, C, GCI, FDX, IBM, and INTC have reported in-line or missed revenues but beat on earnings.
In other words: skew. Just like AAPL is now the core marginal stock of the entire market, just 3 companies, GOOG, IBM and ORCL, and the Financial sector in general (which is neck deep in so much "one-time" DVA and otherwise accounting-based trickery we wouldn't know where to even begin) account for more than 60% of the EPS upside!
Desperate for any good news, EPS estimates have already starting trickling up on earnings season so far:
Both 2012 and 2013 consensus earnings estimates have started inching up (Exhibit 1 – sidebar right). The 2012 EPS estimate, currently at $106.16, reached a near-term bottom of $105.34 in February 2012, while the 2013 estimate troughed at $118.47 in early March versus the current reading of $119.24.
There is however one simple reason why the market is less the jubilant about recent earnings "beats" - they all come on trails of aggressive recent trimmings to near forecasts, all at the expense of hockeysticking latter part of the year expectations.
Consensus revenue growth expectations (excluding energy and financials) are 6.5% in 2012 and 5.8% in 2013. This is lower than the 8.2% growth achieved in 2011. We think it is sensible that the revenue growth expectations are lower for 2012 and 2013 versus 2011 but don’t think estimates embed risks like the 2013 fiscal cliff or a recession in Europe. At the sector level, 2012 earnings growth expectations are highest in financials, technology, and industrials. The lowest growth estimates are in utilities, telecom, and health care.
And the one place where this is more obvious than anywhere: margin expectations, which somehow the consensus see soaring in 2013 after what has now become a very tepid 2012 (despite irrational exuberance toward the mid/late part of 2011).
Excluding energy and financials, incremental margins are expected to contract to 8.7% this year from 13.1% in 2011. 2012 incremental margins have been materially reset lower—the pace of margin reset has been sharp since early June 2011 and margin expectations now appear reasonable. We continue to think the bigger risk is on the revenue line. For 2013, both revenue and incremental margin expectations, at 18.8%, seem high, and we suspect this will come down as the year progresses.
In other words, with much more downside risks associated with the longer-term corporate outlook (fiscal cliff, Europe, China slow down), the market has once again reverted to its "show me" phase, where Q1 results are good, but simply not good enough to where mere hockeysticks in expectations will offset the overhanging fears of a global slowdown. If that is indeed the case, the recent sell-side near-term forecast slashing may end up hurting companies more than benefiting them.
On the other hand, perhaps lower stocks is precisely what the doctor ordered: after all the NEW QE will need not only continued non farm payroll weakness (and flattish inflation of those items that nobody cares about because the Fed just does not track the balance), but also at least another 15% drop in equities from here...
Finally, to summarize earnings season to date: