Each week, we tap the insight of Sam Stovall, Chief Equity Strategist for S&P Capital IQ, for his perspective on the current market.
EQ: The market kicked off Q4 earnings season this week. Earnings estimates have set the bar pretty low. Has Wall Street been too pessimistic towards Q4?
Stovall: Wall Street frequently aims either too high or too low. Last summer, analysts were a little bit too optimistic, expecting that earnings would end up rising about 17 percent in the fourth quarter of 2011. Now, however, as we’re getting into the Q4 reporting season, analysts may have become a little too pessimistic. Their expectations are now a shade below 7 percent for the fourth quarter. So maybe it Q4 2011 results end up being somewhere in between.
What I do find interesting is that at the beginning of each quarter of 2011, analysts estimates were about 45 percent below where earnings ended up being. So if you were to apply that to the final quarter of 2011, instead of getting a 7-percent earnings growth rate year-over-year, the implication could be that we might end up seeing a final number that is closer to 10 percent. Of course, there’s no guarantee that will happen. We’ll have to wait and see, but right now my belief is that maybe Wall Street did set the bar a little too low.
EQ: S&P Capital IQ projects that seven of the 10 sectors will see operating EPS growth for the quarter. Can you talk about some of the sectors that are expected to be among the better performers?
Stovall: Well, as to not keep you in the dark for too long, the sectors that are expected to post year-over-year declines are Materials, Telecom Services, and Utilities. Therefore everybody else is expected to show an increase. The sectors that are expected to show the strongest increases include Energy at about 19 percent, Financials at 10 percent, and Industrials at 7 percent.
One reason that the Energy group is likely to do so well is because of easier year-over-year comparisons. We’ve been seeing oil prices strengthening at about 8.5 percent from December of 2010 versus December of 2011. We also had the Arab Spring, the revolts that took place in many of the Mediterranean countries, which limited supply and increased prices. On top of that, what we find is that refining margins were up significantly, helped by the much wider gap between Brent Crude prices, which are the international oil prices, and the West Texas Intermediate prices. That seemed to help many of the refiners within the group.
Financials are expected to show an improvement, but not necessarily because they are building muscle mass once again. What the banks are doing is releasing some of the reserves that they have held, having thought that they needed those in order to engage in write downs. They did not have to take the write downs, so these reserves are now able to be brought back into their overall earnings. But, I have to say credit quality does appear to be improving and loan growth is also rising by low single digits. So our belief is that the group overall is improving albeit quite slowly.
Lastly, with Industrials, it’s the third-best performing group on an earnings basis but it’s really only a shade above what the average is expected to be for the entire S&P 500. We are expecting to see about a 3-percent growth in global GDP in all of 2011, with most of the gains likely be taking place in the emerging markets, where gains are in excess of 5 percent. But there certainly is not a lot of growth being seen in the developed nations where GDP expansion is likely to be below 2 percent. So Industrials, which do have quite a bit of international exposure, are probably benefitting most from their exposure to emerging nations.
EQ: You touched on the three sectors that are expected to decline for Q4. Can you talk briefly about those?
Stovall: The Telecom Services group is expected to show the deepest decline at about a 10-percent year-over-year drop in operating earnings. The launch of new versions of smartphones will help generate wireless customer growth, but at the same time, many existing customers are upgrading to these high-end items while they’re being subsidized. As a result, we think that there’s going to be lower operating margins that could be hurting earnings. In order to entice customers to trade up to these smartphone devices, Telecom companies have to give an awful lot away, and that probably will hurt in overall earnings. In terms of the wireline operations, we expect to see continued access line weakness being partly offset by broadband subscriber gains, though these additions will likely occur at a slower pace than in the past. So in a sense, narrower margins in wireless and net subscriber losses in wireline could be the reason for Telecom to see a very low double-digit decline.
In terms of Materials, we think that the year-over-year comparison might be a bit tough, particularly for the chemicals and the paper product companies. Also, most of the companies in these groups will experience commodity cost pressure because they are users of a lot of commodities and not just miners of them. So there will be higher commodity and input costs that could end up weighing on profit margins. Also, global growth has been slowing, and we might end up finding out that Europe is already in recession, even though it has not been announced just yet.
Lastly, with Utilities, we expect about a 3-percent decline in earnings. Basically, the fourth quarter is usually a pretty light period for the Utilities sector. We have had a fairly mild winter so far so there has not been a great demand for heat. As a result, there is not a lot of benefit likely to be seen to the earnings of Utilities companies. Plus, a lot of Utilities usually benefit from new household formations, and as we have seen, households have not done a good job of increasing the formations over the last couple of years. It’s also interesting that Utilities were the best-performing sector in 2011 on a total return basis, up close to 20 percent if you include dividends. That was mainly the result of investors seeking an alternative to bonds because they wanted a nice dividend payout but also wanted a fairly low beta, secure capital gains and income growth.
EQ: One of the bigger themes in 2011 was share repurchase programs. Do you see that trend continuing?
Stovall: I do, and it’s not just share repurchase programs but also dividend increases. For non-financial companies in the S&P 500, we estimate that there’s more than $1 trillion of cash on their books that’s just waiting to be used. So when company management feels more confident about the direction of the economy, as well as tax policies that will affect long-term capital programs they engage in, then they will start using that money. In the meantime, because shareholders are basically saying the companies aren’t really earning anything with that cash–since cash is earning well less than 1 percent–then they should do something with it.
S&P Indices recently reported that the payout ratio for companies in the S&P 500 is close to 30 percent as compared with the more normal 50 percent going back to the late 1920s. So we certainly have a long way to go just before getting back to what has been the average over a long period of time.
Also, it appears that there is a deceleration of earnings growth likely to be seen in 2012, so I would not be surprised if companies stepped up their share repurchase program to help support the year-over-year percent changes seen in operating results.
EQ: What are some other trends or announcements that investors should watch for as companies release their earnings?
Stovall: Obviously, it’s nice to know what somebody did for you, but it’s even better to know what they might do for you down the road. Guidance is going to be a very important thing. We saw with Alcoa’s (AA) report to kick off the fourth quarter earnings season that even though earnings had come in weaker than anticipated, because top line growth was favorable and sales were good, that means that it’s not just smoke and mirrors that the company tried to engage in to improve their overall earnings results. There’s actually demand out there for their products.
At the same time, because they had issued relatively favorable guidance, indicating maybe 2012 might actually see an improvement in top-line growth in earnings and so forth, I believe that’s what caused investors to feel more optimistic about the stock and push it up. So corporate guidance is going to be very important to watch for to see whether company management agrees with investors and analysts on a sharp deceleration in earnings growth in 2012.