Corporate America is rapidly losing momentum

SERIOUS MONEY:US STOCK prices have been on a roll in recent weeks and defied the typical seasonal chill, as the major market averages registered their best September gain in more than 70 years. It is now time for corporate America to deliver, as earnings season gains momentum.

The “Great Recession” of 2008 and 2009 has been followed by what has been deemed the “Great Disappointment”, as subpar economic growth has seen the Federal Reserve fail to deliver on its dual mandate of price stability and full employment. The same however, cannot be said of a corporate sector that has registered a phenomenal improvement in profitability in spite of less-than-stellar top-line growth. A firm grip on costs has seen margins jump to within basis points of their all-time high, and profits as a share of GDP stand just one percentage point below the record level registered in the third quarter of 2006.

Investors expect the constituents of the SP 500 to report a 30 per cent year-on-year increase in operating earnings per share for the third quarter on the back of a 6 per cent rise in revenues. The expected numbers are certainly impressive, but it is important to remember that the year-on-year comparisons are still relatively easy; this is hardly surprising given the severity of the contraction that saw 12-month trailing earnings drop by almost 60 per cent from their peak during the summer of 2007 to their nadir last autumn. Perhaps more importantly, earnings per share are expected to drop quarter on quarter for the first time in almost two years.

The stalled momentum, combined with the fact that positive revisions to bottom-up consensus estimates of full-year 2010 SP earnings stalled in mid-May, means investors will be seeking guidance on revenues and margins for the remainder of the year and particularly so given the obvious deceleration in economic growth. Quarterly sales for the SP 500 are still more than 10 per cent below their peak, which is hardly encouraging for employment creation.

It is beyond dispute that the corporate sector’s fortunes are inextricably linked to the economic cycle, and careful analysis suggests that consensus estimates for the year ahead will prove too optimistic. The full-year number for 2010 could be reduced by some $2 to $3 per share in the months ahead, but the cut to 2011 estimates could be far more severe at roughly $8 to $9 per share, as economic reality takes hold.

Corporate revenues are a function of nominal GDP and a simple linear regression confirms that the year-on-year percentage change in quarterly GDP measured in nominal terms, explains almost 75 per cent of the variation in quarterly sales year on year. Revenues are significantly more volatile than the broader economy and GDP growth rates of 3½ per cent or less are typically accompanied by declining sales, while year-on-year revenue increases of 10 per cent or more are associated with economic growth rates above 6½ per cent.

Consensus Wall Street expectations look for an 8 to 9 per cent increase in revenues during the year’s second half, and expect the momentum to continue through 2011. These projections are consistent with nominal economic growth of 6 per cent. However, reliable leading economic indicators point to annualised growth of just 1½ per cent in real terms during the next six to 12 months. Incorporating a relatively constant price deflator, this implies a decline in the pace of year-on-year growth in nominal GDP from roughly 4 per cent during this year’s second quarter to just 2 per cent by next summer. These numbers are simply not consistent with analysts’ current rosy forecasts, and downgrades to top-line numbers are almost assured in the months ahead.

Consensus expectations are that there will be continued improvement in profit margins in the quarters ahead.

However, profit margins exhibit a strong positive correlation with capacity utilisation, and the deceleration in economic growth below potential means that surplus capacity is likely to remain stubbornly high. Thus, margins are likely to peak in the near future, and combined with the revenue shortfall, this suggests that corporate America is unlikely to produce anything better than a single-digit percentage increase in profits during the next calendar year.

Corporate America is rapidly losing momentum and profit growth is likely to slow to a single-digit pace by the first quarter of next year. Investors should note that the earnings upgrade cycle is over and gravitate towards quality.

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