Tuesday, July 30, 2013
The overall mood in the market is expected to remain tentative in today's session as well despite the modestly positive open on positive home price numbers. The economic calendar goes into over drive later this week with the Fed announcement and GDP reports tomorrow and the jobs report on Friday. The market is looking for confirmation that the U.S. economic outlook is improving in a backdrop of continued Fed support.
The two interconnected drivers of the improved U.S. growth outlook relative to the rest of the world include the labor and the housing markets. We will get the latest pulse of the labor market from Friday’s July non-farm payroll reading, which is expected to show ‘headline’ gains around recent monthly levels of a little under 200K. Some acceleration from this level will be highly beneficial, but even sustained gains around current levels should help support steady improvement in consumer spending, the mainstay of the U.S. economy.
The housing momentum is for real as well, but housing is a very interest rate sensitive sector and remains vulnerable to further interest rate increases. The roughly 100 basis point jump in long-term interest rates over the last two months may be just a sign of things to come if the Fed’s ‘Taper’ plan gets underway. The strong gains in this morning’s Case-Shiller home price index appear to run counter to these interest rate concerns. We should keep in mind, however, that this home-price measure is essentially meaningless in gauging current home-pricing conditions as it’s so backward looking – today’s report is for the month of May which only partly overlaps with the period when interest rates started moving up.
Tomorrow’s Fed announcement isn’t expected to shed any fresh light on the ‘Taper’ issue and the growth picture emerging from the Q2 GDP report in the morning isn’t expected to pack many surprises either. The consensus expectation is for GDP growth of about +1% in Q2 after the +1.8% increase in Q1. But the GDP data will be accompanied by revisions to prior data and there could plenty of surprises on that count. It will be interesting to see how the growth numbers for recent quarters and the last few years, particularly since the start of the recovery in 2009, appear with updated numbers.
Accurate data about the recent past is useful, but the markets care far more about forward-looking numbers and the expectation on that front is for the U.S. growth picture to start improving from Q3 onwards. We haven’t seen much evidence of such improvement yet, but that’s what consensus expectations reflect. Similar expectations underpin earnings estimates for the second half of the year and next year as well, though estimates for Q3 have started coming down under the weight of predominantly negative guidance from management teams on the ongoing Q2 earnings calls.
There is some debate in the market as to whether to label the Q2 earnings season as ‘above average’, ‘average’ or ‘below average’. Market bulls cite the record total earnings tally in the quarter, the improved beat ratios on the revenue side relative to the prior quarter and the positive earnings growth picture as reasons for calling it an ‘above average’ reporting season. All of this is true – total Q2 earnings are on track to make a new quarterly record and more companies have beat on the top-line compared to the extremely low level seen in Q1. But the aggregate earnings growth picture is misleading as it primarily reflects gains in one sector – Finance. The growth picture is extremely weak once Finance is excluded from the aggregate numbers. I label the Q2 earnings season as ‘below average’ because of this weak earnings growth picture and the preponderance of weak guidance.
Including this morning’s results from Pfizer (PFE), Merck (MRK), Coach (COH), Aetna (AET) and others, we now have Q2 results from 302 S&P 500 members or 60.4% of the index’s total membership. Total earnings for these 302 companies are up +2.9%, with 65.9% beating earnings expectations. On the revenue side, we have a growth rate of +3.4%, with 49.7% coming ahead of top-line expectations. This compares to total earnings growth rate of +1.8% on +3.7% higher revenues in Q1 for the same group of 302 companies. In terms of beat ratio, 68.2% of these 302 companies had come out with positive surprises in Q1, while only 40.1% had beat on top-lines in Q1. What this tells us that the earnings beat ratio is a bit soft relative to Q1, while favorable top-line surprises are a bit more common.
This aggregate Q2 picture changes materially once the Finance sector is excluded. Total earnings growth turns negative (-3.5% excluding Finance vs. +2.9% including Finance) and even the beat ratios are far less numerous. This lack of breadth in the growth picture is troubling given loftier growth expectations from these sectors in the coming quarters. Given what we have seen outside of Finance in Q2, we will have to bring those expectations down to more realistic levels. That process may have started already, but it still has plenty of room to go.
Director of Research
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