10.12.13: SP 500 Earnings Update: Despite Washington, Earnings Remain a Net Positive – Staying with Financials

October 12, 2013 at 7:51 pm | Posted in BAC, Bond Funds, Bond Market(s), CME, Earnings, Fed Model, Financial sector, Financials, IEF, interest rates, ISRG, MSFT, S&P 500, SCHW, TLT, Uncategorized, WMT | Leave a comment

Per ThomsonReuters, the “forward 4-quarter” estimate this week fell to $118.94, from last week’s $119.04, however the year-over-year growth rate rose to 6.34% this week from last week’s 6.04%.

The p.e ratio on the forward estimate is now 14.3(x).

The “earnings yield” on the SP 500 is 6.98% after this week’s rally, and the Fed Model Spread, which we chart weekly as the difference between the earnings yield on the SP 500 and the closing yield on the 10-year Treasury each Friday, is now 4.6%, versus the record highs of early July, 2012, where the Fed Model was a whopping 665 – 675 bp’s favorable to equities, and the earnings yield was briefly over 8%.

As was mentioned, the growth rate of the forward estimate rose to 6.34%. The highest recorded year-over-year growth rate since early 2012 was 7.30% in mid-September, 2013. We need to break over 7.30% for me to have high conviction that the SP 500 will continue to solidly advance once again. (We always have doubt, it is just the degree of doubt that varies…)

SP 500 earnings growing at roughly 6.5% for calendar 2013 (ThomsonReuters currently estimates full-year SP 500 earnings growth at %5.7%), are in line with their post WW II long-term growth rate of 7%, with the probabability that SP 500 earnings will modestly strengthen over the coming year, as corporations battle the horrid fiscal policies, and the confidence-destroying antics emanating from Washington. Remember, Corporate America, particularly the SP 500 can’t “control” revenues: top-line growth is a function of product / service demand, and the economy. Corporate America does have complete control over “expense” growth, and it is one way to manage earnings. Lower compensation, less hiring, lower spending on SG&A. We have spreadsheets on 80 – 100 of the SP 500, and I guarantee you in this environment, Corporate America is throwing expense and capex dollars around like sewer covers. Washington just doesn’t get it: the US economy is about growth, and it remains sub-par.

Q3 ’13 earnings are lapping the weakest SP 500 earnings growth from q3 ’12, which was just +2%. The probability remains better than average that we see a 7% – 8% quarter of earnings growth this quarter, which will only average to +5%, if we combine q3 ’12 and q3 ’13, (or what is better known in retail as the 2-year comp). 8% earnings growth seems far-fetched given the headlines, and the sentiment, but Europe is now stable, Japan is improving, and the US dollar was weaker through q3 ’13, particularly versus the euro and the yen.

Why monitor the growth rate of the “forward 4-quarter” estimate ?  

In a nutshell, the reason we track the forward estimate growth rate and y/y change is that (in my opinion) it is the one metric that validates or “explains” an expansion (or contraction) in the SP 500′s p.e ratio, or what is otherwise known as P.E expansion. Although I can’t prove it mathematically, it seems intuitive that if the growth rate of the forward estimate is increasing, then the SP 500′s p.e ratio can “expand” to keep pace with the presumed acceleration in “earnings expectations” or contraction as the forward growth rate slows.

Just like the bond market and the Federal Reserve are more concerned with “inflation expectations” than actual inflation that we can see in the data, I think the one component missed by strategists and the CNBC community is “earnings expectations” and the growth therein, and the one metric that quantifies this expectation is forward earnings, and yet we hear about it so very little.

Are there errors with this model or methodology ? You betcha, and it was a big one in 2008. The SP 500 forward earnings metric didn’t peak out until July, 2008 when the forward estimate topped at $102 and change. When we look at our old data and see that the July 4th, 2008, forward estimate was $104.07 (the high print for the SP 500 until late 2011, early 2012, when that estimate was exceeded), we remained bullish for far too long into the 2008 – 2009 recession, based on earnings data, and despite what “market action” was telling us. (Warrenn Buffett’s classic saying comes to mind, “beware of geeks bearing models”.)

So what is the lesson learned ? Every model (including any and all market and stock valuation models) are flawed in some way. Every investor should have their own style and methodology, but it shouldn’t be relied upon exclusively.  We think studying the SP 500 earnings data from ThomsonReuters and Factset are very important inputs to the market and individual stock valuation exercises, but we also use technical analysis, and (hopefully) good old fashioned horse sense to arrive at our market conclusions and portfolio holdings.

Today, based on low expectations, we think that SP 500 earnings and forward expectations of SP 500 earnings remain a net positive for the stock market, and we think it highly likely that over the next 12 – 14 months, that SP 500 earnings and earnings growth will contribute positively to SP 500 performance. Although the US economy is growing at a sub-par rate, the fact is the economy is relatively stable, and that just about every asset-class excess of the last 25 years (with the exception of possibly bond funds and bond investing) has been shocked back into normal expectations about long-term investing risk and reward.

In the next week or two we are going to publish on this blog, a study of the SP 500 earnings since the mid-1980′s, showing both dollar estimates for the years, and the returns for the SP 500 therein. You’ll probably be surprised at the data and the SP 500 performance relative to the data.

Stay tuned.

Staying with Financials:

One of our assumptions for the calendar 4th quarter, 2013, was that Financials would outperform based on expectations for earnings growth, and normal capital market and SP 500 returns for the last quarter of the year, which is traditionally the strongest of the year in terms of “average” SP 500 returns. We remain long names like Goldman Sachs (GS), Schwab (SCHW) and JP Morgan (JPM) given their capital market and asset sensitivity to the market returns. We also like CME, and Wells Fargo (WFC), and Bank of America (BAC). Names on the radar currently not owned are Morgan Stanley (MS), Ameritrade (AMTD) and Chicago Board of Options Exchange (CBOE).

Here is the full-year earnings expectations data for the Financial sector, for calendar 2013 per ThomsonReuters:

10/11/13: +19.8%

10/1/13: +20.1%

7/1/13: +18.1%

4/1/13: +15.4%

1/1/13: +16%

Financial’s are the only SP 500 sector to see earnings estimates INCREASE during the course of 2013: some of that is reserve releases, as consumer balance sheets are much healthier today, than at any time in the past 3 years, while some is the capital market returns generated by an SP 500 that was up 19% as of 9.30.13, which has helped reinvigorate the IPO market and M&A (to some degree).

For Q3 ’13 and Q4 ’13, here is the trend in quarterly earnings growth expectations for Financials:

10/11/13: +8.6% and +24.3%

10/1/13: +9.4% and +25.2%

7/1/13: +12.5% and +25%

4/1/13: +11.3% and +24.6%

1/1/13: +12.2% and +26.1%

For the 2nd quarter, 2013, Financials saw their initial +20% growth escalate to 30% by the end of July, after reserve releases and trading revenue data were revealed in the financial results.

Relative to the SP 500, Financial sector earnings are growing at 2(x) the rate of the SP 500 at lower p.e ratio’s for the stocks and the sector as a whole.

Pundits attribute the reserve releases negatively saying a release of a credit reserve isn’t “earnings” but not saying that when the reserve is increased, that this wasn’t a reduction to earnings. In other words, they aren’t treating reserve additions and releases equally in the quality of earnings discussion. Tom Brown, whom I like and read regularly, makes the exact same point on his blog, www.bankstocks.com. You can’t have it both ways.

For me, the right way to look at bank valuation is on pre-tax, pre-provision profits, or what is called or known as PTPPP. Similar to operating income for an Industrial or Non-Financial.

There are about 10 weeks left in the trading year, for 2013. We should start to see Financials start to move shortly. Our plan currently is to reduce some of our Financial’s weighting by the end of Jan ’14. I dont think 2014 will see the same level of earnings growth for the sector. If we do not start to see a move in Financials by the week of 10/18 or at the very latest by 10/25, we have to re-think our positions.

Conclusion: since Oct 1, q3 ’13 earnings growth expectations, have fallen from +4.6% to +3.8% from October 1, to October 11. This is somewhat unusual since the pattern has been that earnings growth expectations get revised too low, and then once earnings start to get reported, the expected growth rate starts to tick higher. The biggest drag is Energy which has seen q3 ’13 expected earnings growth for the sector fall from -0.7% on 10/1/13 to -4.7% as of 10/11/13. Both Chevron and Exxon Mobil face easier compare’s in q3 ’13, which tells me that Energy estimates might have gotten too negative in the last few weeks.

Only Utilities has a higher expected growth rate for q3 ’13 as of 10/11/13 than 10/1/13, with the expected sector growth rate of 0.9% versus 0.8% on 10/1.

Only 29 companies have reported q3 ’13 earnings per ThomsonReuters, but by the end of next week or October 18, there will be close to 100 having reported. This coming week will be a better tell in terms of results.

Interesting metric: for q4 ’13, only Industrials have seen their expected sector growth rate revised higher since October 1,’13, from +17.3% to +17.7%. Not a large amount, but it is the direction that sticks out. The other 9 SP 500 sectors saw downward revisions to expected q4 ’13 earnings growth, which is more “normal”.


Ryan Detrick of Schaeffer’s out of Cincinnati, with another great article on the VIX this week. The SP 500 ended the week, just 19 point shy of its all-time high, yet given the negative sentiment (again) you would think the key benchmark is at 1,000 and headed south. Ryan and I both went to a small private college within the city of Cincinnati, and we had breakfast on Thursday morning in Cincinnati with another school friend that is a broker. Ryan has been on fire this year, in terms of his stock picks and market calls. Strictly a technician too. Makes me wonder why I spent time getting a Finance degree, an MBA and a CFA. The charts provide important info – don’t ignore technical analysis, and make it another tool within the investing tool box. In the article, Ryan tells readers that this coming week is October expiration, and that this week has been positive for the SP 500 (in terms of returns) for 7 of the past 10 years. Detrick also continues to like small-cap and mid-cap stocks. We are long both the IWM and the MDY for a trade. It is a shame Detrick wasn’t chosen as one of the top 100 to follow on Twitter. Have to wonder who did that survey…

Great new blog by Gary Morrow and friends out in California. The chart of the TLT fits with the bearish sentiment around bonds noted by Ryan Detrick in the past few weeks. Lowest level of bullishness amongst bond investors in years, per Detrick. So what has changed ? I think Yellen will be viewed as bond-market-friendly given some of the more measured perspectives I’ve heard, which could drive a decent rally in the Treasury complex. The fact that we had a very powerful 2-day rally in the stock market on Thursday and Friday, with little give back in the 10-year Treasury tells me something. However, we would still get worried if the 10-year Treasury yield traded below 2.40%. The 10-year Treasury yield put in a series of highs at 2.39% around March 19th, 2012. That yield high held until this summer of 2013. Below that 2.39% yield, and I think the equity market has a problem.

Norm Conley of JA GLynn out of St. Louis: truly amazing that stock fund investors are selling again, given the 5% correction in the SP 500. That is what I mean about sentiment: the fact that people get so scared, so quickly regarding stock returns and the prospect for another prolonged bear market, is one good explanation as to why stock returns are so good this year, i.e. the contrarian sentiment play.

Bob Lang, a friend from our www.TheStreet.com days, likes Nike. We sold Nike long ago (foolishly) but the stock is more expensive than Amazon (AMZN) today on a cash-flow basis. I think NKE is or was trading at 25(x) cash-flow the last time we wrote about it, while AMZN, a stock where the mis-informed always talk about its valuation (which on a p.e basis is ridiculous) at over 100(x) ’13 consensus EPS. We do think Amazon is more of a cash-flow than an earnings story. (Long one small position in NKE since 2004. Long AMZN too.)

Jeff Miller at a Dash of Insight: this is last week’s article, but note the graph of gasoline prices from Bespoke. Retail is still getting whacked, despite the drop in gasoline. This is what must be driving the angst over consumer spending. Wal-Mart (WMT), Macy’s (M), and Abercrombie (ANF) are the most interesting. We’ve been waiting on a buy level for Macys (M) for years. Under $40 and M gets real interesting. Abercrombie & Fitch (ANF) is getting washed out technically. Dont follow it fundamentally. Have traded ANF in the past, with nice gains. Another opportunity lining up to own ANF – almost there.

Good chart by Phil Pearlman on the 5-year Treasury. We posted it because everyone talks about the 10-year Treasury (as do I) but the 2-year and 5-year are ignored. Still given Treasury sentiment, it looks like the 5-year yield could rally all the way down to 1.15% (from its current 1.43% yield) and the bears would still be in control. Treasury sentiment, Yellen, and such could be lining up for still more of a rally in Treasuries.

Intuitive Surgical (ISRG) had a good week, this week, up 7%. Technicals look like they are turning. We went long some between $390 – $395, but sold for a 4% loss. Hard to find oversold stocks in this market. (none)

Do fundamentals matter any more ? All the smart guys these days seem to be technicians. What a waste of an education. Seriously, I feel that way these days. I have a 600 line spreadsheet on Intel and numerous other names that I’ve tracked for years, and a gaggle of idiots in Washington, makes it all seem worthless. When i completed the CFA exam in 1994 – 1995, there was one technical analysis question on the whole test (3 year timeframe). That to me is a huge failure on the part of AIMR. Incorporating technical analysis into our process has helped dramatically the last 10 – 13 years.

Love Josh Brown: like Cramer, he covers a large amount of ground on any single day. Here is his link to Josh’s weekend blog, TRB, and notes from he and Barry’s conference, “The Big Picture”. Note his summary of the panels and the lone bull from the group. Like we’ve noted here, the complete lack of enthusiam about this stock market, is the one key element that is keeping a bid under stocks. (Or at least that is our opinion…) (Have to make this conference next year, for sure…)

Good article from Valuewalk on ValueAct, the lower-key activist hedge-fund that announced a position in MSFT near $27. Read the whole article. We are still long MSFT, and like the sudden burst of activity in the company. While we dont confuse activity with accomplishment, I think that at least MSFT is trying some different approaches, which they can afford to do given the huge cash-cow Windows and Enterprise will be. What is amazing to me is that MSFT has $7.5 – $8 net (of debt) cash per share, similar to AAPL, and has the AAA balance sheet, but no activist puts pressure on MSFT to issue debt at the cost of the dividend, and buy back huge amounts of stock, as has been suggested AAPL will do. What am I missing ?

We own Oakmark Funds for many smaller clients. Great process as detailed here at Vitaliy Katsenelson’s Valuex Vail annual summer conference in Vail. Vitaliy used to write for the www.street.com too. Smart kid – great story. Would love to hit that conference some year although I’d walk into the presentations chanting “we’re not worthy” with the likes of Harris & Associates and Jim Chanos in attendance.

Another reason to be bullish, this time from Marketwatch, and the “cash is still king” argument.  10 years from now, we will look back at the SP 500 at 1,700 and say “What were we thinking ?”

Summary: still overweight equities in the standard 60% / 40% asset allocation and still long a little extra duration, given sentiment around the bond market. Our muni ETF’s (HYD and MUB) trade like there is a piano on their respective backs. Our muni closed-end funds (MEN and NUV) look heavy too. Puerto Rico needs to get out of the headlines.

Thanks for reading and stopping by:

Trinity Asset Management, Inc. by:

Brian Gilmartin, CFA

Portfolio manager









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