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Looking Behind Earnings Growth

Several market pundits have dismissed the notion that the market has sold off during earnings season because companies have lowered their expectations for the second half. They note that earnings growth estimates for the third and fourth quarters have increased since the end of the second quarter. Since the end of the second quarter, third quarter earnings growth forecasts have increased by 130 basis points to 15.0% and fourth quarter growth in now predicted to be 15.6% versus 15.3% five weeks ago. Additionally, first quarter 2005 estimates have increased as well. Rising growth forecasts for the second-half of the year combined with much better than expected earnings growth during the first two quarters this year has pushed the projected earnings growth for 2004 from just 12.8% at the beginning of the year to 18.9% currently. This is actually higher than the 18.4% growth in S&P 500 earnings in 2003.

Those of a more bearish persuasion counter that earnings growth on a quarterly basis is decelerating and negative pre-announcements have increased. On a quarterly basis, year-over-year earnings growth peaked in the fourth quarter of 2003 at 28.3%. Earnings growth during the first and second quarters this year were 27.5% and 25.3% (2Q is still an estimate) respectively, with third quarter forecasted to be a less robust 15.0%. Earnings pre-announcements following the second quarter were more negative than following the first quarter. Of the 139 companies that have issued guidance for the third quarter, 50% have been negative and 31% positive. After the first month following the first quarter this year, only 33% of pre-announcements were negative, while 47% were positive. While earnings pre-announcements were more negative than the first quarter, they were on par with the year earlier period that saw 52% negative versus 23% positive.

The argument that S&P 500 earnings growth is decelerating from previous quarters, while future estimates are increasing is captivating investors, and digging a little deeper into the numbers offers some clarity.

By looking at earnings growth projections by industry sector it is easier to see what is driving the upward revisions for the S&P 500 earnings growth for the rest of the year. The table below details the expected earnings growth for the S&P 500 along with each of the ten industry sectors as defined by Standard & Poor's as of last Friday as well as last month.

  Third Quarter 2004 Fourth Quarter 2004
  July 1 Aug 6 July 1 Aug 6
Cons. Discretionary 25% 22% 17% 16%
Consumer Staples 9% 8% 12% 11%
Energy 16% 28% 14% 22%
Financial 7% 10% 13% 13%
Health Care 9% 9% 16% 16%
Industrials 16% 16% 14% 15%
Materials 61% 70% 58% 72%
Technology 38% 35% 23% 20%
Telecom -13% -14% -3% -5%
Utilities 4% 3% 10% 10%
S&P 500 13.7% 15.0% 15.3% 15.6%

The materials and energy sectors have experienced the largest increase in earnings estimates for the third and fourth quarters. Third quarter earnings forecasts are also being lifted by the financial sector and since the financial sector makes up over 20% of the S&P 500, the 300 basis point increase in earnings growth actually accounts for a good portion of the increase. Unfortunately, earnings growth in the energy and materials sectors does not bode well for most other companies or the economy. The surge in commodity prices has led to amazing earnings growth for energy and materials companies. Analysts have been playing catch-up all year for both sectors. At the beginning of the year, earnings for energy companies were expected to decline by 14% during the third quarter on a year-over-year basis. While not expected to have declining earnings, the materials sector was expected to increase earning by 40%. While that is very high, it now stands at 70%.

We have discussed higher commodity prices for quite a while. We now see evidence that these higher prices are causing firms' costs to increase. According to Nucor, steel prices have increased $218 per ton to $575 since the second quarter of 2003 and $120 since the first quarter this year. Transportation companies have added on surcharges that customers have to pay. These rising costs are starting to be felt by other companies, like consumer discretionary. The increased revenue at one company translates into higher costs at another.

Whirlpool is one company that has been hit on with these increased costs. Whirlpool in turn has increased prices and added to their own fuel surcharges. Retailers will either pass along the higher cost to consumers or eat it themselves. So either, retailers will end up losing profitability or consumers face more inflation. A company like Whirlpool has another disadvantage as it is one of the few manufactures of consumer durable goods that are made in the US and at a profit. As Asian manufacturers continue to increase their breadth of products and manufacturing capacity, their cost advantage will be undoubtedly pressure domestic manufacturers. American manufacturing has been gutted due in part to the strong dollar policy that started about a decade ago and there are few dominant domestic manufacturers left. Toyota has essentially caught up with Chrysler as the number three nameplate in the U.S. And now there is speculation that Sears will start offering appliances from Asian manufactures to help take back market share. This would obviously catapult the Asian manufactures market shares quickly. Will US appliance makers go the way of US television manufacturers?

Also, since the end of the quarter, consumer discretionary and technology have under performed the S&P 500, while energy, materials, and financials have outperformed. All have declined, but less than the S&P 500. Additionally, the consumer discretionary and technology sectors have higher weightings in the market capitalization weighted index. In fact, consumer discretionary and technology comprise 27% of the S&P 500, while energy and materials make up only 10%. This overweighting by the worse performing groups put additional pressure on the overall index.

Even though earnings growth forecasts have increased since the end of the second quarter for the S&P 500, it has not been across the board. Two important sectors have actually had their expected growth rates trimmed. Additionally, financial companies have experienced upward earnings revisions for the third quarter and financial stocks have performed better than the overall market recently. But the financials have benefited from extremely low short-term interest rates that have already started to tick back up. Earnings growth will slow as the yield curve flattens out and should not be expected to provide an additional boost to the overall earnings of the S&P 500. In fact, analysts have not raised earnings forecasts for the fourth quarter for financials, while for the other sectors the changes mirror the third quarter, just not in magnitude. It does appear that investors are starting to ratchet down expectations and stock prices are dropping accordingly.

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