Q4 Earnings

Q4 earnings: they made me a pessimist

Econoday Short Take 2/11/09
By Mark Pender, Senior Writer, Econoday

The fourth-quarter earnings season is still dragging on as companies, not surprisingly, are in no hurry to post their results. With two-thirds of the season in the books, data courtesy of Thomson Reuters show year-on-year profit growth for the S&P 500 down just over 41 percent. The quarter began with high expectations but has slid day by day since.

The graph below tracks S&P 500 profits over the past seven years. Companies posted consistent and often very strong profit growth until third-quarter 2007, one quarter ahead of the recession. Profits (blue bars) have contracted every quarter since the third quarter of 2007 and look to continue to contract based on the outlooks for the first and second quarters (outlined bars at right of graph).

There are countless factors offered to explain the movement of the stock market, including financial factors, economic factors, and sometimes even astrological factors. One factor that does track convincingly with the stock market is change in corporate profits. The graph below combines the above graph with a graph of year-on-year change in the S&P 500 index. Only twice, at the pivot of the business cycle, did the direction of stock market change not match up with directional change for profits. The degree of the changes are also matching tightly at a decline of 40 percent for stocks in the fourth quarter against the latest count of a drop of 41 percent for profits and a decline of 24 percent for stocks in the third quarter against a drop of 19 percent in profits. So far in the first quarter, the S&P 500 is at a year-on-year decline of 44 percent, a bit ahead of the 29 percent drop in the outlook for profits — a mismatch that anticipates further contraction in profits.

The outlook matters
I keep telling myself that analyst outlooks matter. But each quarter, year after year, analysts over-estimate corporate results by a mile. In their defense, analysts base their estimates on the company's estimates. Either way, optimism is the system, the system by which company outlooks are offered to the public and priced into the stock market.

Going into the earning season at the beginning of the month, analysts expected virtually no change in profits — no change vs. the current decline of 41 percent. The quarter before, analysts expected virtually no change for third-quarter profits which ended up sinking 19 percent. Their performance is not improving.

Analysts' outlook for the first quarter, which had been up 30 percent at this time last quarter, currently calls for a 29 percent contraction followed by a 25 percent contraction in the second quarter. If the usual overstatement applies, actual contraction may prove much worse.

The government's tally of corporate profits is very slow with the latest data available only for the third quarter. The graph below compares changes in the S&P 500 index (red line) with changes in corporate profits (blue line). The blue line has already peaked, at an annual rate of just over $1.5 trillion in third-quarter 2007. Profits for the third quarter 2008 were $1.3 trillion — a level that is certain to fall.


Bottom Line
If the first-quarter earnings season proves as bad as the current season, this time next quarter the red bars and lines of the S&P 500 index will likely be pointing downward once again. Keeping track of company news and tracking earnings are central to the understanding of the financial markets and the outlook for the economy.

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