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Another Good Season

July 28, 2011
Political difficulties in agreeing on pressing public debt problems in the US and Europe have been unnerving markets recently. Underneath the worrisome headlines, US corporate earnings and profit margins continue to beat forecasts. Barring an unexpected major policy mistake, most equity markets are therefore likely to rise to new highs sooner or later.

Earnings season to gain momentum world wide
The corporate earnings season for the second quarter of 2011 is in the third week in the US. It is gaining momentum in Europe and just starting in China and Japan. The first indications from the US are positive, including in industries that rely on capital investment activity and corporate demand. Revenue growth has accelerated by more than predicted, despite signs of moderating economic growth in the US and elsewhere. Earnings per share, on average, surpassed the consensus forecast by a margin that was bigger than at the revenue level, suggesting that profit margins continue to defy some analysts’ concerns that they may have peaked. This is primarily valid in the manufacturing and information technology industries, including software services. The percentage of companies beating expectations rebounded to the average level of the current bull market. In short, US corporate profitability continues to improve at a faster-than-anticipated rate on a broad basis, rather than a sector- or company-specific basis.

US profitability continues to improve and remains underestimated
About 35% of the S&P 500 members have published results to date. EPS rose by 18.2%, or 7.5% above consensus. Growth was led by materials, energy, information technology and industrials. In terms of surprises, the winners were led by information technology, financials, consumer discretionary, and health care. On the revenue side, growth was higher than expected in all sectors and positive in all sectors except financials (which face slow private credit growth as consumers shy away from taking on new debt.) Cyclical sectors thus continue to perform best, but defensive sectors, such as health care, are now doing better than in previous quarters - a sign that growth has spread to reach more stable business segments.

Earnings growth above long-term average and broad-based
Overall quarterly earnings growth has slowed from a peak rate of more than 80% at the start of bull market in 2009, but is still clearly higher than long term averages. Last but not least, growth is not limited to a few companies or sectors. The percentage of companies that beat estimates jumped to an average of about 74% since the start of the season. The average from the start of the bull market to the previous earnings season was around 73%. The 2003-2007 bull market average was 67%. Strong reporting season and bullish market price signals The strong earnings season is not surprising, given the positive price signals that we had observed in recent weeks. Equity markets, especially in the US, have been suggesting that the economic outlook is still positive, if not about to improve. These signals contradict the fact that the public debt issues have made the outlook more uncertain as well. However, despite the government policy and debt related concerns, market segments that typically rise when economic conditions are improving had surged to new historic highs just before the start of the reporting season: the Dow Jones Transportation Index rallied to a new historic high on July 7th. The S&P 600 Small Cap Index did the same on the next day. Importantly, these records were registered as the number of rising stocks increased. Such a combination of rising prices and improving market breadth is usually a sign that more gains lie ahead. It is also worth noting that the Nasdaq 100 Index rallied to a new cyclical high last Friday as well.

Fundamental data does not imply weak industrial demand in US
Economic and corporate data does not necessarily signal a significant slowdown in the months ahead, either. Manufacturing statistics continue to suggest strength outside the non-consumer segment of the US economy. Furthermore, companies that generate 80% or more of their business at home, such
as steel maker Nucor (sales breakdown: 97% US, 3% Canada), were among the businesses that reported positive earnings surprises. In its outlook, Nucor warned of increasing steel imports. That is perhaps an unwelcome competition, but not a sign of weak demand from US manufacturing. Good earnings and rising stock prices among small capitalization companies, which typically also rely on the home market for business, point to the same idea. Thus, the bull market is likely to remain intact despite the much-discussed debt concerns in the US and Europe.