Corporate profits bottoming out
Econoday Short Take 5/6/09
By Mark Pender, Senior Financial Writer, Econoday
The first-quarter earnings season has proven to be one of the very best in memory, showing very few negative surprises and helped by major improvement in bank earnings. With about three quarters of the season over, profits for the S&P 500 are down 34.7 percent on the year. That sounds bad of course but it's no surprise, and that's what turns out to be the surprise. During the seven quarters of ongoing profit contraction, final results have routinely come in far below expectations. To what degree current share price gains in the financial sector are tied to the accounting switch to mark-to-model from mark-to-market is uncertain but the switch certainly hasn't hurt. With all the major firms having reported except AIG, financials in the S&P 500 are posting a net $13 billion net profit for the first quarter versus a net $74 billion loss in the fourth quarter of 2008. Two thirds of financial firms are now beating estimates. No wonder bank shares have been rallying strongly over the past three weeks, lifting the whole stock market with them. (Earnings data courtesy of Thomson Reuters unit First Call).
Base effects pending
Profits have been on such a long deep slide that comparisons are now very easy, a factor that looks to make for outsized gains in the quarters ahead. In the graph below, the solid blue bars represent actual year-on-year quarterly profit change over the past six years. The open bars on the right side of the graph are analyst expectations for the coming quarters. The rate of contraction is expected to hold steady in the ongoing quarter and then ease in the third quarter. But against the dreadfully easy comparison of fourth quarter 2008, fourth quarter 2009 profits are expected to jump 165 percent!
The S&P 500 index has really been rallying this year, now holding at 900 and up from a low of 666.79 in early March. That was when word came of income improvements at Citigroup and Bank of America, news that started the whole rally which is now being fed further by the financial sector's actual results. There are plenty of factors behind share values, too long to list. But changes in profits are without a doubt right at the very top.
Profit growth exceeded stock market appreciation through much of 2004 through 2006. Then profit growth slowed and began to contract, this while share prices kept going higher. Note that contraction in S&P profits first appears in third-quarter 2007, preceding the economic recession by more than a full year. For the past year, changes in profits and changes in share prices have been in line. Were the second quarter to end today, profits and share prices would be almost perfectly in line.
Earnings season primer
The two- to three-week approach to an earnings season is often a touchy time for the stock market. Company news is light and the news that is released is often negative as companies who have done poorly come clean in what is known as the confession season. This confession season was actually positive, with the S&P 500 moving from about 780 in late March to over 850 by early April.
The exact dates for an earnings season are difficult to pin down but they're centered in the months immediately following the end of a calendar quarter. The graph below tracks changes in the S&P 500 from the beginning of an earnings season (red bars) to what we'll consider to be the end of the season at month end (gold bars). April 1st may be a day for fools but it also would have been a very good day to have gone long the stock market, as shown on the very right of the graph. The S&P 500 rose 7.6 percent in the month of April and is up 13.3 percent when adding the three trading days of May. But the gain has to be compared against the 11.4 percent loss of January's fourth-quarter 2008 earnings season and the massive 16.6 percent loss in the third-quarter 2008 earnings season of October.
Profit data definitely support hopes that economic recovery is on the way. But it's important to remember the base effect, namely that the prior contraction has pulled current levels to a much lower level. But levels have stabilized and, as hinted at by the 165 percent gain expected for the fourth quarter, improvement from these levels may very well be something to see. Should profits improve, foreign investment into U.S. equities could become an important factor for the market. Foreigners have been pulling their money out of the U.S. market over the past year-and-a-half. But the emergence of profit growth would no doubt pull foreign money off the sidelines, feeding what could be a very nice rally for U.S. stocks.