S&P 500 Earnings…Is that right?
December 31, 2008 7:15 am
There is an interesting battle going on. On one side is the tag-team of the Fed and the Treasury. On the other is corporate America’s ability to maintain profitability in the face of this severe downturn. Sometimes they are working together with a common goal, while other times they seem at odds.
Take a read of this interesting discussion from Jon Markman’s Strategic Advantage Newsletter (Also, definitely take him up on the 2-week free trial):
Earnings in the sink
Last week, we talked about the potential for continued broad-market weakness as the hotshot analysts on Wall Street continue to slash earnings forecasts in line with deteriorating economic conditions. These new estimate cuts will sour sentiment, inflate P/E multiples and generally make life difficult for the bulls trying to bust the market higher out of the current range.
So now we are seeing two sides emerge to fight on the early January ring on Wall Street. In the green trunks dotted with bull faces, we have New Year optimism, government intervention, and monetary policy support. In the red trunks marked with bear faces, we have falling earnings, rising global tension, a bleak employment outlook, home price collapse and bankruptcies.
So how serious are these earnings estimate cuts? Well, according to a study late last week by Thomson Reuters, the current estimated fourth-quarter earnings growth rate on the S&P 500 has just gone into negative territory at -0.9%, down from +65% in August and +0.5% last week. You can see this progression in the chart below. A majority of the decline is tired to downward estimate revisions in the financial, materials, consumer discretionary, and energy sectors.
What’s worrisome is that despite the reductions taken so far, more is on the way. Of the 10 sectors that comprise the index, the financials are still expected to be the largest contributor to fourth-quarter earnings growth. Analysts are looking for earnings of $5.3 billion versus a $16.1 billion loss last year. Without the financials, quarterly earnings for the S&P 500 would fall to -14.2%.
Within this sector, investment banks and brokerage houses are the largest contributors. Even with the myriad of Federal Reserve lending facilities that have allowed investment banks to offload decaying debt and derivative products in exchange for loans or Treasury instruments, it’s hard to see a turnaround of that magnitude happening so quickly. If it did, this would be the first quarter of profitability since mid-2007.
Banks are trying to minimize losses via cost cutting, but it’s revenue side of the picture that has been annihilated for these guys. Just last month JPMorgan Chase (JPM) closed its proprietary trading desk, greatly reducing its ability to directly profit from short-term movements in stocks, bonds and commodities. A record number of M&A deals were canceled this year, bringing a sharp decline in lucrative advisory fees for traditional investment bankers. And of course, the asset management business has been smashed; just ask investors who lost $1 billion in Goldman Sachs’ hedge funds.
As you can see, just by isolating the financials a strong case can be made for double-digit earnings declines for the S&P 500 heading into 2009. On top of this, you don’t need to do much mental jujitsu to make bearish cases for many of the other sectors as U.S. economic output likely fell off the cliff this quarter: Merrill Lynch (MER) economists are looking for fourth-quarter GDP to clock in at -6.7%, down from a -0.5% decline in the third quarter. It doesn’t get much better looking out into 2009, where the economy is expected to shrink another -3.1%.
Any way you look at it, earnings estimates still have a long way to fall as the fixed asset deleveraging ravages profit margins, and analysts are likely to remain behind the curve. Although anything can happen, we remain skeptical going into the start of the year even if begins with a bang.