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Our spies decode the earnings season
The hidden signals are mostly good, suggesting healthy economic growth on the horizon. Overconfidence is a weak spot.
By Michael Brush
A few weeks back, we suggested the best way to get a read on the economy this earnings season was to look beyond the actual profit numbers and focus instead on several snippets of intelligence, as Donald Rumsfeld likes to say.
Everyone knew that earnings growth would be weak and that companies would be meeting profit targets primarily because of cost-cutting. The real signs of growth -- or trouble -- would be found elsewhere.
Now, with much of the earnings season behind us, our market spies report back that our snippets of intelligence paint an encouraging picture.
About the only bad sign is that investors have turned too optimistic about a recovery -- meaning they could scatter for the exits on any signs of weakness. But the optimists wont have any reason to run away, provided we get decent follow-through in the economy on signs of strength in the snippets of intelligence below.
Snippet 1: Sales were decent
With cost-cutting so widespread these days, beating analyst earnings estimates isnt what it used to be. The better gauge is sales growth, which turned out to be quite solid, for the most part.
Alex Motola, of Thornburg Investment Management in Santa Fe, N.M., was looking for anything better than a 5% gain in sales at S&P 500 companies. Sales growth is coming in at 9% so far. I think that speaks well for the future, as long as we can get some jobs back in the economy, says Motola.
To be sure, a 44% advance in sales at energy companies has accounted for a third of that 9% sales gain. And that performance cant be expected to sustain itself, especially if volatile energy prices stay lower. The spot price for domestic crude oil, which topped out at nearly $40 a barrel in March, was at $28.50 on Tuesday.
On the bright side, sales growth of 9% at consumer discretionary companies is a reassuring sign that people are still opening up their wallets for stuff other than necessities. Companies such as Marvel Enterprises (MVL, news, msgs) and Hasbro (HAS, news, msgs), for example, got some of the best upward earnings estimate revisions in the group for the quarter, suggesting continued strong business trends at these companies.
Health care was also solid, with 15% sales growth. The best estimate revisions came at firms such as Endo Pharmaceuticals (ENDP, news, msgs), American Pharmaceutical Partners (APPX, news, msgs), DJ Orthopedics (DJO, news, msgs), Novoste (NOVT, news, msgs) and Bio-Rad Laboratories (BIO, news, msgs). Semiconductor and basic materials companies saw gains of 8% to 13%; this was a particularly good sign because these sectors tend to strengthen first in the early days of a recovery. Telecom-equipment providers saw continued weakness in sales, and software sales growth was lackluster, as well. So were sales at information technology and technology stocks in the S&P 500, as sales advanced a mere 3% in these groups.
Snippet 2: Recovery hopes werent postponed
For the past several earnings seasons, the hoped-for economic revival two quarters down the road kept getting pushed back, discouragingly. This quarter, for the first time in a while, we got some good news. So far, expectations for an economic revival in the second half of 2003 are hanging steady.
That is a very positive development, says Chuck Hill, who closely tracks earnings results at Thomson Financial. It does not guarantee that we will see that pick up. But we dont have to shoot it down like we did in the past.
Look at sales forecasts, and theres more encouraging news. Projected second-half revenue growth for all U.S. companies has advanced to 2% to 4% from 1% to 2% before this earnings season, says Joseph Kalinowski, chief investment officer at Ehrenkrantz King Nussbaum in New York. Mostly its in cyclical and higher growth areas, and that would suggest rebound in economy. Companies are much leaner now, so if these revenue numbers come to fruition, it is going to impact the bottom line significantly.
Equally encouraging was sustained strength in second-half estimates at companies that serve as bellwethers for capital spending increases. That means technology, basic materials and industrial companies. Of these, only basic materials saw any significant trimming of estimates for the second half, says Hill. Companies in these groups with the best upward numbers bumps include Broadcom (BRCM, news, msgs), Micrel (MCRL, news, msgs), Dow Chemical (DOW, news, msgs), Arch Chemicals (ARJ, news, msgs), Celgene (CELG, news, msgs), SM&A (WINS, news, msgs), Stratasys (SSYS, news, msgs) and Gundle/SLT Environmental (GSE, news, msgs).
Mark Petrie, of Hokanson Capital Management in Encinitas, Calif., warns that all this could turn out to be another head fake in the form of inventory building. It will take a couple of quarters to see if demand is high enough for a sustained increase in capital spending, he says.
Indeed, Merrill Lynch analyst Steven Milunovich cautions that profit margins in many sectors are still below the cost of capital -- not a recipe for robust capital spending. A March survey of managers by Goldman Sachs, released May 7, found 2003 capital spending overall remained unchanged. But tech budgets were cut. Among the few projected areas of tech strength: security software and hardware, and mobile connectivity such as wireless local area network systems.
Snippet 3: Credit quality got a little better
We had identified credit quality trends as key to the economy, and this quarters report card showed improvement. This is a good sign for the economy because it means fewer people are having trouble paying off their debt.
Encouragingly, charge offs on credit-card debt at Capital One Financial (COF, news, msgs) declined to 8.2% this quarter, from 8.6% last quarter.
That may not sound like much, but its a positive signal after months of troubling deterioration. Its a sign that we have more time for the fiscal and monetary stimulus to run its course and turn the economy around, says Hokanson Capitals Petrie.
On the business side, conditions improved, too. The ratio of non-performing assets at FleetBoston Financial (FBF, news, msgs) fell to 2.4% in the first quarter of this year, from 2.87% in last years fourth quarter, says Petrie. Write-offs even declined in the most troubled sectors like airlines, telecom and merchant energy.
Snippet 4: No more companies suspended guidance
Before this earnings season, many high-profile companies -- McDonalds (MCD, news, msgs), Sun Microsystems (SUNW, news, msgs), AT&T (T, news, msgs) and others -- had simply suspended all earnings guidance, refusing to offer any input on analyst expectations.
Analysts were worried that more would join the crowd, a possible sign companies simply didnt want to talk about bad news. Encouragingly, few companies joined this group this quarter.
Snippet 5: Transportation stocks hung in there
Watching transport companies can tell you a lot about the outlook for the economy because, after all, they link producers and customers. Second, they use a lot of energy, so how their stocks behave reflects the markets outlook for energy prices. Third, transport stocks have a lot of debt; that means their actions can tell us a lot about the markets attitude on bankruptcy and loan-default risk.
For these reasons, continued outperformance by the Dow Jones Transportation Average ($DTX.X) this earnings season was a sign of economic strength ahead. Weve certainly seen even more of a breakout in the transports than we saw a few weeks ago, and strength in the industrials has confirmed that, says John Hussman, an economist whose Hussman Strategic Growth Fund (HSGFX) has advanced an impressive 47% since its launch in July 2000. It may strike investors as arcane, but historically those confirmations are important.
Snippet 6: Companies didnt use the war as a scapegoat
In late 2002 and early 2003, seasoned investors snickered when a parade of companies blamed the Iraq war for their poor results. Vain corporate managers often cite some external event for their poor performance. (The current scapegoat is SARS.) So bulls were looking for signs this earnings season that the war really had been a problem for businesses and that conditions did improve after the conflict wound down.
There were tentative signs this was the case. Cruise operators Royal Caribbean Cruises (RCL, news, msgs) and Carnival (CCL, news, msgs) were naturally jittery about the wars effect on business. But they turned in decent results. More importantly, they reported that bookings improved as soon as the war ended, points out John LaForge, a money manager with the Phoenix-Hollister Value Equity Fund (PVEAX). Semiconductor companies were also cautious leading up to the earnings season. But several -- such as Broadcom or Micrel -- blew away their earnings-estimate numbers.
Many companies reporting early in April -- Symantec (SYMC, news, msgs) and Overture Services (OVER, news, msgs), for instance -- offered a cautious outlook. But the balance seemed to shift towards more positive guidance later in the quarter, says Timothy Ghriskey of Ghriskey Capital in Greenwich, Conn. It appears to us that a pickup in business evolved during April, says Ghriskey. Companies offering a more favorable outlook later in the reporting season included retailer Chico's FAS (CHS, news, msgs), Comcast (CMCSK, news, msgs), EchoStar Communications (DISH, news, msgs) and AdvancePCS (ADVP, news, msgs).
Snippet # 7: We could use a little more fear
Contrarian investors think too much confidence among your fellow investors is a bad thing for a couple of reasons. First, it suggests theres not much money left to flow into the market and drive up your stocks. Next, overconfident investors get spooked more easily by bad news -- so they can drive stocks down hard if anything negative crops up.
Unfortunately, investors are looking pretty cocky right now, cautions market analyst and contrarian investor Phil Erlanger of Erlanger Squeeze Play. First, he cites the volatility indices -- or tools that measure anxiety levels by tracking stock-option volatility. (Higher numbers mean more anxiety.)
The Nasdaq Volatility Index ($VXN.X) of the Chicago Board Options Exchange (CBOE), for example, fell below 32 a week ago before firming up to nearly 33. Thats lower than levels hit during any of the fizzled rallies in the past three years of this bear market. And the CBOE Market Volatility Index ($VIX.X), now at about 22, is closing in on levels of 20 seen last spring just before the market sold off dramatically.
I did not see enough fear, Erlanger says.
Next, not enough investors are placing negative bets by going short. Investors and traders are short about three days' worth of trading volume in S&P 500 shares. That's very near the all-time low of 2.6 days' worth of volume, says Erlanger. New data on short sales are due out next week.
Another sign of overconfidence: The Investors Intelligence survey of market newsletter writers shows a level of bullishness (56%) often associated with market highs.
All this has Erlanger wondering whether theres a sell-off ahead. If so, it might naturally come during the seasonally weak late summer and early autumn months, or even earlier.
That said, if you believe in the snippets of intelligence offered above -- and most snippets this quarter were clearly bullish, suggesting healthy economic growth on the near horizon -- any such sell-off could offer an attractive buying opportunity.
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