Weekly Market Commentary - Global Profit Recession

This quarter is shaping up to be the worst quarter for corporate profits in three years when the recovery was just getting underway, as the United States joins Europe and China in experiencing falling profits. The currently sluggish U.S. economy, European recession, and slowing Chinese economic growth—not to mention the threat of the fiscal cliff—all suggest that this is probably not the last quarter of disappointing earnings growth.

This quarter we will be watching three factors to help us gauge the extent of the earnings slowdown: the stall in manufacturing, the peaking of profit margins, and the impact of share buybacks.

 

Global Profit Recession

In the absence of further policy action in Washington or Europe following recent major events, attention this week turns from macroeconomic events to microeconomic as the earnings pre-announcement season heats up. As the quarter draws to a close, companies provide guidance as to how their earnings are shaping up for the quarter. Not only will companies provide guidance this week about how they fared during the quarter, but also, 11 S&P 500 companies will actually report their earnings for the third quarter.

While policy events such as moves by the Federal Reserve (Fed) or leaders in Europe garner the attention of traders and move the markets from week to week, it is actually the long-term growth of earnings that drive the stock market over longer periods of time that matters most to investors. Illustrating the importance of earnings growth even during the policy-dominated—some might even say distorted—markets of the past few years, is the fact that earnings growth and stock market performance has been the same since the recovery began. The trailing-four-quarter total earnings per share for S&P 500 companies has risen 82% since the first quarter of 2009, as economic momentum began to improve. During the same time period since the end of the first quarter of 2009, the S&P 500 index has gained 83%. Earnings drive stocks, but the momentum is now stalling.

This quarter is shaping up to be the worst quarter for corporate profits in three years when the recovery was just getting underway. In the third quarter, earnings are expected to have fallen -2% from a year ago and from the prior quarter. The United States is joining profit declines expected around the world, including Europe (-22%) and China (-1%). So far, 112 S&P 500 companies have issued guidance for the third quarter with a ratio of negative-to-positive guidance of 4.3 to 1. This 4.3 ratio is the weakest showing in over a decade and well above the average of 2.3. As an example, last week FedEx, a global economic barometer, lowered its earnings guidance and warned about “the slowdown in the global economy and global trade.”

The economic backdrop to the quarter’s revenues and profits has been soft as the recent retail sales and industrial production data for August attest. The rise in total spending outpacing income growth suggests an unsustainable pace of spending confirmed by August retail sales advancing just 0.1%, when excluding auto and gasoline sales. In fact, sales in clothing, general merchandise, and electronics stores posted outright declines. Businesses are also having it tough. Industrial production fell 1.2% in August, the biggest drop since March 2009.

While the first drop in profits in three years is worrisome by itself, it is not just this quarter that is of concern to investors, it is the outlook for earnings in future quarters, as well.

Despite the poor showing likely in the third quarter, our long-held outlook for 7%* earnings growth in 2012 appears to be on track relative to the year-ago consensus estimate by Wall Street analysts of 15%. The Wall Street analyst consensus for the profit growth of S&P 500 companies in 2013 is 12%. The currently sluggish and slowing U.S. economy, the ongoing European recession, and slowing Chinese economic growth all weighing on revenue growth combined with the diminishing impact of expanding profit margins to lift earnings beyond revenue growth [Figure 1]—not to mention the threat of the fiscal cliff—all suggest that this estimate is again likely too high. Low-to-mid single-digit earnings growth is probably the best we can hope for in 2013, while outright declines are not out of the question.

The three factors we will be watching most closely among the earnings news this quarter are:

  • • Stalling manufacturing – We will be watching to see the impact on profits the global stall in manufacturing activity has on the economically sensitive Materials and Energy sectors.
  • • Peaking profit margins – Examining how broadly and in which sectors profits can exceed the pace of revenue growth can tell us how much further profit margins may have to expand and help drive earnings per share.
  • • Shrinking share count – To what extent and in what sectors share buybacks allow for positive earnings per share growth despite shrinking net income.

These factors will help us gauge the extent of the earnings slowdown and its trajectory for coming quarters, crucial for stock market investors.

IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Earnings per share (EPS) is the portion of a company's profit allocated to each outstanding share of common stock. EPS serves as an indicator of a company's profitability. Earnings per share is generally considered to be the single most important variable in determining a share's price. It is also a major component used to calculate the price-to-earnings valuation ratio.

The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

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This research material has been prepared by LPL Financial.

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