Earnings estimates are suffering from a bout of weakness these days, writes Michael Krause of AltaVista Independent Research, a New York consultancy that specializes in fundamental analysis of exchange traded funds, or ETFs. In a newly minted report, Krause observes that for 2006 forecasts “we are seeing sustained and accelerating revisions to the downside. Over the past month, 2006 estimates for seven out of nine sectors declined….” He adds that the slide is “the fastest rate of decline since we began monitoring 2006 estimates back in July 2005.”
Krause’s report comes at an anxious moment, given all the debate about whether the economy is, or isn’t poised for a stumble. Indeed, the mixed signals emanating from recent economic releases has Wall Street abuzz about what comes next for the stock market. In search of clues, we interviewed Krause via email….
In your latest research report, you write that “we are seeing sustained and accelerating revisions to the downside.” Give us an overview of what’s going on. Is the earnings cycle finally turning?
We still expect that S&P 500 earnings will increase this year. What’s different is that expectations are now on the decline, whereas for the past two years estimate revisions were almost universally positive, even excluding the effect of Energy earnings on the S&P, which everyone recognizes played a big part.
The accompanying graph (see below) illustrates the trend in 2006 earnings estimates since July of last year. Estimates for the S&P 500 as a whole rose through November and then started to decline. But excluding Energy, estimates that had remained stable through last summer began to weaken in the fall and have started to decline at a faster rate more recently.
Historically, trends in estimates revisions tend to persist for some time. That is, they don’t haphazardly move up/down from month to month, so the downward trend, now established, could well continue. After two years of being behind the ball on the strength of corporate earnings, Wall Street analysts might now be too optimistic at a time when earnings growth is quite naturally slowing in this, the fifth year of a profit recovery.
However, the fact that Wall Street gets its numbers wrong need not spell doom for the market. Even if negative estimates revisions were to continue apace, S&P 500 earnings would likely end the year up around 6%. That’s not as high as the 11.4% suggested by current consensus estimates, but still in-line with the post-WWII average of 6.2%.
Is the downshift in earnings estimates for 2006 limited to any one or two sectors for the S&P 500, or is the trend more broadly based?
It appears to be fairly broad based. Over the past month, estimates for seven out of nine sectors declined; only Energy and Industrials were up. And since July 2005, when we began monitoring estimates for 2006, only Energy and Utilities were up significantly. Particularly weak were Consumer Discretionary estimates, down 3.4% since July, and Consumer Staples, down 4.5%, which is disturbing for a supposedly defensive sector.
Again, overall the problem appears to be one of expectations and not necessarily fundamental weakness in earnings. For example, if consensus expectations are to be believed, the Consumer Discretionary sector–home not only to retailers but autos and homebuilders–will show a 17.4% increase in earnings this year. That’s faster than all other sectors–driven by a huge increase in margins from already high levels. Earnings for the sector may in fact increase this year, but the 17.4% figure seems particularly optimistic.
How important was the energy sector for S&P 500 earnings in 2005, and how does that compare with the outlook for 2006?
Last year Energy accounted for about 40% of the S&P’s 14% earnings growth, and was the biggest contributor. Although oil prices are an obvious wild card, current estimates suggest Financials will replace Energy as the biggest contributor to S&P earnings growth in 2006, accounting for about 28% of the total, while Energy will fall to second or third place, accounting for around 17%.
How does the outlook for 2006 earnings translate when it comes to breaking the S&P 500 into value and growth slices? Does one look better than the other?
S&P, in concert with Citigroup, recently changed from a single-factor methodology (based on price-to-book value) to a multi-factor methodology to divide the world into Growth and Value. For the S&P 500, it has introduced Pure Growth and Pure Value indices, as well as plain (or ‘not pure’) Growth and Value indices. The pure indices include only stocks with strong characteristics one way or the other; the plain indices divide the market cap of stocks without strong growth or value characteristics and place half in each index, thus blurring the distinction.
Unfortunately, the only readily tradable vehicles, the iShares S&P/Citigroup Growth and Value exchange traded funds (NYSE: IVW and IVE, respectively) track the plain indices. One of the criticisms we have of the prior single factor methodology was that price-to-book value had almost no relationship to earnings growth. And in fact over the past five years companies in the Value index grew earnings faster than those in the Growth index! Oddly enough, even under the new methodology that problem appears to persist, with Growth companies expected to grow aggregate earnings by 10.6% in 2006, and Value companies expect to grow earnings by 12.1%.
In all fairness, according to consensus expectations for long-term earnings growth going forward, firms in the Growth index are expected to post slightly faster earnings growth than those in the Value index. That said, Growth (IVW) is currently trading at a P/E of 16.3x estimates for 2006, while Value (IVE) is trading at 13.7x. Also worrisome for Growth is the fact that two of the weakest sectors mentioned above, Consumer Discretionary and Consumer Staples, together account for 27% of the Growth index, but are limited to 13% of Value.
Does the 2006 outlook for small cap earnings generally also raise some warning flags?
As a whole, earnings for the S&P Small Cap 600 index are on the decline, though not as fast as for the blue-chip S&P 500. The almost universal refrain that after six years of outperformance by small and mid caps, its blue chip’s turn to shine is overdone in our opinion.
While it is true that small and mid caps are now slightly more expensive than large caps, trading at a P/E of 17.3x and 16.9x this year’s estimates, respectively, versus 14.9x for the S&P 500, they also offer much faster earnings growth that leaves more room for analyst error. Current expectations are for small and mid cap earnings growth of 19.6% and 21.7% in 2006, respectively, compared with 11.4% for the S&P 500. Even if those estimates prove to be optimistic to the tune of five or six percentage points, you still end up with a small and mid cap earnings growth rate of more than double that for the S&P 500.