Pragmatic Capitalism

Capital for Living a More Practical Life


By Dirk Van Dijk, CFA, Zacks Investment Research

Key Points:

  • With third quarter reports done we shift focus to fourth quarter expectations. Annual rankings now based on 2012, not 2011 expectations. The third quarter was a good one. Total reported earnings growth of 13.4%. Ex-Financials growth is 17.7% year over year. Total revenue growth 10.37%, 13.14% ex-Financials. Median earnings surprise 2.72% and median sales surprise 0.62%.
  • At start of earnings season, total growth of 9.7% and 12.2% ex-Financials was expected.
  • Year over year growth expected to slow to 3.40% in fourth quarter, 7.64% excluding Financials. Down 3.12% sequentially, 5.54% decline expected ex-Financials. Dramatic slowdown, but easy hurdle to clear. Revenue grow expected to slow to 3.40%, 7.64% ex-Financials. Sequentially, Revenue to fall 0.80%, but rise 1.53% ex-Financials.
  • Full-year total earnings for the S&P 500 jumps 46.5% in 2010, expected to rise 14.7% further in 2011. Growth to continue in 2012 with total net income expected to rise 9.9%. Financials major earnings driver in 2010. Excluding Financials growth was 28.2% in 2010, and expected to be 17.9% in 2011 and 7.6% in 2012.
  • Total revenues for the S&P 500 rise 7.95% in 2010, expected to be up 5.92% in 2011 and 5.26% in 2012. Excluding Financials, revenues up 9.35% in 2010, expected to rise 9.61% in 2011 and 5.53% in 2012.
  • Annual Net Margins marching higher, from 5.88% in 2008 to 6.27% in 2009 to 8.51% for 2010, 9.21% expected for 2011 and 9.62% in 2012. Margin expansion major source of earnings growth. Net margins ex-Financials 7.79% in 2008, 6.93% in 2009, 8.12% for 2010, 8.74% expected in 2011 and 8.91% in 2012.
  • Revisions ratio for full S&P 500 at 0.90 for 2011 (neutral), at 0.77 for 2012 (bearish). Ratio of firms with rising to falling mean estimates at 0.96 for 2011 (neutral), 0.73 (bearish) for 2012. All down from last week. Total revisions activity past peak and plunging.
  • S&P 500 earned $548.4 billion in 2009, rising to $788.7 billion in 2010, expected to climb to $904.5 billion in 2011. In 2012, the 500 are collectively expected to earn $994.0 billion.
  • S&P 500 earned $56.80 in 2009: $83.18 in 2010 and $95.39 in 2011 expected bottom up.  For 2012, $104.87 expected. Puts P/E’s at 14.84 for 2010, and 12.94x for 2011 and 11.77x for 2012, very attractive relative to 10-year T-note rate of 2.05%. Top-down estimates: $96.83 for 2011 and $102.66 for 2012.

The Earnings Picture

Third quarter earnings season was a good one. Total net income growth was far higher than expected, although the median surprise and the ratio of positive surprises to disappointments is slightly below normal.

This week we will change our focus to the expectations for the fourth quarter. The year-over-year growth rate for the S&P 500 is expected to slow dramatically, to just 4.62% from 13.44% in the third quarter. Excluding Financials, the growth slowdown is expected to be even more dramatic, dropping to just 3.97% from 17.7%.

Keep in mind, though, that at this point in the third quarter earnings season the expected level of earnings growth was just 12.04%, and 11.73% excluding the Financials. Thus, it is not inconceivable that we might squeak into double-digit growth again in the fourth quarter.

Earnings growth is slowing on both sides. Revenue growth is expected to slow to 3.40% from 10.37% year over year. Excluding Financials, revenue growth is expected to slow to 7.64% from 13.14% in the third quarter. Sequentially, revenues are expected to be down 0.80% overall, and up just 1.53%.

Net Margins Expansion Slowing

As revenue growth is slowing, so to is the rate of net margin expansion. Overall net margins are expected to climb to 9.11% from 8.94% a year ago, but excluding Financials, net margins are expected to actually fall to 8.45% from 8.74% last year. Sequentially net margins are expected to be down both in total and ex-Financials from 9.35% and 9.07%, respectively.

The net margin expansion game is getting long in the tooth, but it does not look like it is entirely over. It has played a key role in the remarkable earnings recovery we have seen since the depths of the Great Recession.

On an annual basis, net margins continue to march northward. In 2008, overall net margins were just 5.88%, rising to 6.27% in 2009. They hit 8.51% in 2010 and are expected to continue climbing to 9.21% in 2011 and 9.62% in 2012. The pattern is a bit different, particularly during the recession, if the Financials are excluded, as margins fell from 7.78% in 2008 to 6.93% in 2009, but have started a robust recovery and rose to 8.12% in 2010. They are expected to rise to 8.74% in 2011 and 8.91% in 2012.

Full-Year Expectations Still Good

Total net income in 2010 rose to $788.7 billion in 2010, up from $538.4 billion in 2009. The expectations for the full year are very healthy. In 2011, the total net income for the S&P 500 should be $904.5 billion, or increases of 46.5% and 14.7%, respectively. The expectation is for 2012 to have total net income come close to $1 Trillion mark to $994.0, for growth of 9.9%.

Consider those earnings relative to nominal GDP. If we use the middle of the year GDP level, S&P 500 net income has climbed from 3.89% in 2009 to 5.45% in 2010, and assuming that the 2011 expectations are on target, 6.02% this year. Of course, the S&P 500 earns a lot of its income abroad, and there are a lot more than 500 companies in the U.S. so to some extent that is an apples-to-oranges comparison. Nevertheless, it does demonstrate that corporate profits are doing a heck of a lot better than the rest of the economy.

A much broader measure of (domestic only) corporate profits tracked by the government rose to 9.92% of GDP in the third quarter. Since 1959 (when the data starts), that measure has averaged 5.99% of GDP. It is still not a record, though, that was set in the third quarter of 2006 at 10.29% of GDP. Meanwhile, wages fell to a record low of just 43.75% of GDP, while the average since 1959 is 48.42% of GDP.

Higher profits are great for the stock market, but ultimately companies need customers, and their customers need to have income (or borrowing capacity). Thus there has to be a very real question about the sustainability of these great earnings. I don’t think it is wise to assume that corporate profits will continue to take an ever larger share of the economic pie.

The “EPS” for the S&P 500 is expected to be over the $100 “per share” level for the first time at $104.87 in 2012. That is up from $56.80 for 2009, $83.18 for 2010, and $95.39 for 2011. In an environment where the 10-year T-note is yielding 2.05%, a P/E of 14.8x based on 2010 and 12.9x based on 2011 earnings looks attractive. The P/E based on 2012 earnings is just 11.8x.

Estimate Revisions Drying Up

Estimate revisions activity is well past its’ seasonal peak and is plunging (seasonally normal). We saw a little bit of a bounce in the ratio of upwards to downwards revisions, especially for this year, but now that bounce seems to be over. Once again, there are more estimate cuts than increases, with a 0.90 ratio. That is still in neutral territory.

However, the situation for 2012 is not as good. There the ratio never got above 1.0 during the earnings season, and has now also started dropping again, and currently stands at 0.77. That is a slightly bearish reading.

To some extent, there is a mechanical reason for upwards revisions to this year. After all, the third quarter is part of the full year, so if a company beats by, say, a nickel and the analysts don’t increase their estimates for the firms by at least that much, they are implicitly cutting their numbers for the fourth quarter. With almost three positive surprises for every disappointment, one should expect more upwards revisions than cuts.

Many of those increases are now falling out of the four-week moving totals. That suggests that on balance the guidance given in the earnings conference calls was negative.

At the sector level, with the drop in overall revisions activity, the sample sizes are getting quite thin, which makes them somewhat less significant, but that does not mean that they should be ignored entirely. For 2012, the estimate cuts are very widespread. There are just two sectors — Industrials and Retail — that have seen more upwards than downwards revisions for 2012, and Retail just barely (1.08 ratio).

Meanwhile, five sectors have at least two cuts per increase. Autos, Aerospace and Business Service are faring the worst, but on very thin sample sizes. Financials still have a large number of total revisions, and there the ratio is 0.49.

The Industry Winners (& Losers)

As far as sectors are concerned, it looks like the clear winner in the third quarter was Energy. It won gold by a healthy margin for both earnings and revenue surprise, as well as for revenue growth. It took home silver for earnings growth, edged out by Construction, which was coming off a very low base a year ago. There was no clear-cut loser for the quarter, but Utilities, Aerospace and Financials were all candidates for that dubious distinction.

The third quarter was a good one. However, the expectations are very subdued for the fourth quarter, and the hurdle is getting lower. Looking ahead to the first quarter, that slowing is expected to continue, with just 1.04% total, and 2.62% ex-financial growth expected.

Expected Quarterly Growth: Total Net Income

  • Total net income is expected to be just 3.40% above what was reported in the fourth quarter of 2010, down from 10.37% growth in the third quarter. Excluding Financials, growth of 7.64%, down from 13.14% reported in the second quarter.
  • Relative to the third quarter total net income to fall 0.80%, ex-Financials to rise 1.53%.
  • Construction to lead the way (low base in 2010), followed by Energy and Transports.
  • Financials the only sector to see growth accelerate from the third quarter, six sectors expected to see negative year-over-year growth.


Quarterly Growth: Total Net Income Expected
Income GrowthSequential Q1/Q4 ESequential Q4/Q3 EYear over Year 4Q 11 EYear over Year 1Q 12 EYear over Year 3Q 11 A
Oils and Energy0.50%-49.48%22.98%2.90%60.06%
Business Services-5.53%-12.81%12.24%14.83%20.10%
Industrial Products19.99%-21.40%9.18%12.12%25.22%
Consumer Discretionary-10.73%6.92%3.56%6.26%13.28%
Computer and Tech-12.09%6.93%2.76%2.27%9.31%
Consumer Staples-4.87%-6.82%-1.14%3.22%6.28%
Basic Materials48.69%5.64%-4.06%-1.94%35.29%
S&P 500-0.95%-3.12%4.62%1.04%13.44%
Excluding Financial-0.86%-5.42%3.97%2.62%17.70%

Quarterly Growth: Total Revenues Expected

  • Revenue growth for the 374 yet to report expected to fall to 7.20%, from the 12.48% growth posted in the second quarter. Growth ex-Financials 8.83%, up from 7.42% in 2nd quarter.
  • Sequentially revenues 4.22% lower than in the second quarter, down 2.01% ex-Financials.
  • Five sectors expecting revenue growth over 10%, Finance to see sharp 24.2% year-over-year drop in revenues.
  • Revenue growth expected to slow sharply in fourth quarter falling to -0.14%, 1.45% ex-Financials.


Quarterly Growth: Total Revenues Expected
Sales GrowthSequential Q1/Q4 ESequential Q4/Q3 EYear over Year 4Q 11 EYear over Year 1Q 12 EYear over Year
3Q 11 A
Oils and Energy-3.74%-3.56%17.98%-0.49%32.05%
Consumer Discretionary-6.90%4.94%11.41%8.74%14.74%
Industrial Products6.13%-5.68%10.61%10.69%18.37%
Basic Materials5.72%-2.63%8.47%7.00%19.20%
Computer and Tech-5.47%7.03%7.75%7.35%11.34%
Business Services-3.31%1.70%5.99%5.40%11.39%
Consumer Staples-9.57%-7.24%-4.20%-6.00%10.97%
S&P 500-3.82%-0.80%3.40%0.34%10.37%
Excluding Financial-4.15%1.53%7.64%3.00%13.14%

Quarterly Net Margins Expected

  • Sector and S&P net margins are calculated as total net income for the sector divided by total revenues for the sector.
  • Net margins expected to rise to 9.11% from 8.94 a year ago, but down from 9.35% in the third quarter. Net margins ex-Financials expected to fall to 8.45% from 8.74% a year ago and down from 9.07% in the second quarter. Is margin expansion coming to an end?
  • Seven sectors see year-over-year margin expansion, nine expected to see contraction.
  • Margin expansion the key driver behind earnings growth. Due to seasonality, it is best to compare to a year ago, particularly at the individual company and sector levels. Mix of companies reporting will lead to big changes in both the reported and expected net margin tables from week to week.


Quarterly: Net Margins Expected
Net MarginsQ1 2012 ExpectedQ4 2011 Expected3Q 2011 Reported2Q 2011 Reported1Q 2011 Reported4Q 2010 Reported
Computer and Tech15.45%16.61%16.00%16.81%16.21%17.42%
Business Service12.11%12.39%11.96%11.60%11.11%11.70%
Consumer Staples11.43%10.87%11.35%11.07%10.41%10.53%
Consumer Discretionary8.99%9.38%10.44%9.36%9.20%10.09%
Oils and Energy8.40%8.05%8.72%8.57%8.13%7.72%
Industrial Products8.81%7.79%8.66%8.69%8.69%7.89%
Basic Materials8.71%6.19%7.33%9.06%9.50%7.00%
S&P 5009.35%9.11%9.35%9.12%9.27%8.94%
Excluding Financial8.74%8.45%9.07%9.11%8.77%8.74%

Annual Total Net Income Growth

  • Following rise of just 1.9% in 2009, total earnings for the S&P 500 jumps 46.5% in 2010, 14.69% further expected in 2011. Growth ex-Financials 28.15% in 2010, 17.94% in 2011.
  • For 2012, 9.89% growth expected. 7.62% ex-Financials.
  • Thirteen sectors expected to see total net income rise in 2011 and all in 2012. Utilities only (small) decliner in 2010. Eight sectors expected to post double-digit growth in 2011 and nine in 2012. Only Utilities, Autos, Energy and Health Care expected to grow less than 5% in 2012.
  • Cyclical/Commodity sectors expected to lead in earnings growth again in 2011 and into 2012. Materials, Industrials and Energy expected to grow over 30% for second year.
  • Sector dispersion of earnings growth narrows dramatically between 2010 and 2012, only Construction and Financials (low base) expected to grow more than 20% in 2012, eight grew more than 30% in 2010.


Annual Total Net Income Growth
Total Net Income Growth2009201020112012
Construction– to –– to +-10.60%55.35%
Finance– to +324.70%-0.20%22.17%
Industrial Products-34.97%36.49%32.56%17.89%
Consumer Discretionary-14.99%23.14%19.72%13.63%
Business Service1.47%13.59%18.11%13.55%
Basic Materials-47.21%56.36%35.31%10.54%
Computer and Tech-5.52%47.10%22.94%8.83%
Consumer Staples5.46%11.65%8.85%8.11%
Auto– to +1499.15%16.03%2.28%
Oils and Energy-54.89%50.46%39.28%1.96%
S&P 5002.10%46.48%14.69%9.89%

Annual Total Revenue Growth

  • Total S&P 500 Revenue in 2010 rises 7.95% above 2009 levels, a rebound from a 6.41% 2009 decline.
  • Total revenues for the S&P 500 expected to rise 5.92% in 2011, 5.26% in 2012.
  • Industrials, Materials and Energy to lead revenue race in 2011. Four other sectors (all cyclical) also expected to show double-digit revenue growth in 2011.
  • All sectors but Staples, Finance and Aerospace expected to show positive top-line growth in 2011, but four sectors expected to show positive growth below 5%. All sectors but Energy see 2012 growth, but only Construction, Tech and Industrials seen in double digits.
  • Aerospace the only sector to post lower top line for 2010. Revenues for Financials, Construction, and Conglomerates were virtually unchanged.
  • The widespread revenue gains are not consistent with the idea of a double-dip recession, particularly in a low inflation environment.
  • Revenue growth significantly different if Financials are excluded, down 10.56% in 2009 but growth of 9.35% in 2010, 9.61% in 2011 and 5.53% in 2012.


Annual Total Revenue Growth
Sales Growth2009201020112012
Computer and Tech-3.84%15.49%13.13%12.40%
Industrial Products-20.96%12.34%18.88%11.81%
Basic Materials-16.96%11.22%18.39%8.88%
Consumer Discretionary-10.97%5.30%11.97%8.75%
Business Service-3.61%4.81%9.20%6.76%
Consumer Staples-0.52%4.79%-2.01%5.48%
Oils and Energy-34.24%23.74%18.64%-0.83%
S&P 500-6.41%7.95%5.92%5.26%
Excluding Financial-10.56%9.35%9.61%5.53%

Annual Net Margins

  • Net Margins marching higher, from 5.88% in 2008 to 6.27% in 2009 to 8.51% for 2010, 9.21% expected for 2011. Trend expected to continue into 2012 with net margins of 9.62% expected. Major source of earnings growth.
  • Financials significantly distort overall net margins. Net margins ex-Financials 7.78% in 2008, 6.93% in 2009, 8.12% for 2010 and 8.74% expected in 2011. Expected to grow to 8.91% in 2012.
  • Financials net margins soar from -8.42% in 2008 to 15.42% expected for 2012.
  • All sectors but Medical and Utilities saw higher net margins in 2010 than in 2009. Thirteen sectors expected to post higher net margins in 2011 than in 2010. Widespread margin expansion currently expected for 2012 as well with 13 sectors expected to post expansion in margins.
  • Sector net margins are calculated as total net income for sector divided by total revenues. However, there are generally fewer revenue estimates than earnings estimates for individual companies.


Annual Net Margins
Net Margins2009A2010E2011E2012E
Computer and Tech11.72%14.92%16.22%15.70%
Business Service9.97%10.81%11.69%12.43%
Consumer Staples9.68%10.31%11.46%11.74%
Consumer Discretionary7.27%8.51%9.09%9.50%
Oils and Energy5.93%7.22%8.47%8.71%
Industrial Products6.07%7.37%8.22%8.66%
Basic Materials4.91%6.91%7.90%8.02%
S&P 5006.27%8.51%9.21%9.62%
Excluding Financial6.93%8.12%8.74%8.91%

Earnings Estimate Revisions: Current Fiscal Year
The Zacks Revisions Ratio: 2011

  • Revisions ratio for full S&P 500 at 0.90, down from 1.33 two weeks ago, now neutral. Total revisions activity plunging, change in revisions ratio driven more by old estimates falling out, not new ones being added (lower significance to changes in the revisions ratio). Thin samples in many sectors.
  • Five sectors with revisions ratio above 1.0, one above 2.0. Four with two cuts per increase or more. Industrials and Discretionary lead, Autos and Business service very weak.
  • Ratio of firms with rising to falling mean estimates at 0.96, down from 1.08 last week, still a neutral reading.
  • Total number of revisions (4-week total) past seasonal highs and plunging, at 1,498, down from 2,064 last week (-27.4%). Increases at 708 down from 1,147 (-55.3%), cuts at 788, down from 917 (-14.1%).


The Zacks Revisions Ratio: 2011
Curr Fiscal Yr
Est – 4 wks
Industrial Products0.531153894.222.20
Consumer Discretionary-0.31121351351.460.92
Consumer Staples0.15161156401.401.45
Oils and Energy-2.341822107921.160.82
Computer and Tech-1.923311121650.680.74
Basic Materials-0.3491013210.620.90
Business Service-1.242113160.190.18
S&P 500-0.612022117087880.900.96

Earnings Estimate Revisions: Next Fiscal Year
The Zacks Revisions Ratio: 2012

  • Revisions ratio for full S&P 500 at 0.77, down from 0.90 from last week, back in bearish territory.
  • While better than in recent weeks, the failure of the revisions ratio to rise more significantly as activity has picked up is a very worrisome sign, the positive surprises are not translating into higher 2012 expectations.
  • Only two sectors have positive revisions ratio (above 1.0). Four sectors with more than two cuts per increase. Autos and Aerospace very weak.
  • Ratio of firms with rising estimate to falling mean estimates at 0.73, down from 0.79 last week. Still in bearish territory.
  • Total number of revisions plunging (4-week total) at 1,673, down from 2,178 last week (-21.2%). Thin samples for many sectors.
  • Increases at 726 down from 1,031 last week (-29.6%), cuts fall to 947 from 1,147 last week (-17.4%).


The Zacks Revisions Ratio: 2012
Next Fiscal Yr Est – 4 wks
Firms Up
Firms Down
Ests Up
Ests Down
Firms up/down
Industrial Products0.417829151.930.88
Basic Materials-0.4971322221.000.54
Consumer Discretionary-0.4291743460.930.53
Oils and Energy-1.2216241321520.870.67
Computer and Tech-0.5128271021280.801.04
Consumer Staples-0.3282136530.680.38
Business Service-0.32675120.420.86
S&P 500-0.531772447269470.770.73

Total Income and Share

  • S&P 500 earned $538.4 billion in 2009, rising to earn $788.7 billion in 2010, $904.5 billion expected in 2011.
  • The S&P 500 total earnings expectations dip below the $1 Trillion mark in 2012 at $994.0 Billion. Finance share of total earnings moves from 5.9% in 2009 to 17.9% in 2010, dip to 15.6% expected for 2011; rebound to 17.3% in 2012, but still well below 2007 peak of over 30%. Energy share also rising going from 11.9% in 2009 to 14.9% in 2011, dip to 13.8% in 2012.
  • Medical share of total earnings far exceeds market cap share (index weight), but earnings share expected to shrink from 17.3% in 2009 to 11.1% in 2012, down each year.
  • Market Cap shares of Construction, Staples, Retail, Transportation, and Business Service sectors far exceed earnings shares of any of the years from 2010 through 2012.
  • Earnings shares of Energy, Finance, Autos, Materials and Medical well above market-cap shares.
  • As a general rule, one should try to overweight sectors with rising earnings shares, underweight falling earnings shares, but also over weight sectors where earnings shares exceed market cap shares.


Total Income and Share
Income ($ Bill)Total
$ 2010
$ 2011
$ 2012
% Total
S&P Earn
% Total
S&P Earn
% Total
% Total
S&P Mkt
Computer and Tech$135,462$166,542$181,24817.18%18.41%18.24%18.92%
Oils and Energy$96,418$134,290$136,92512.23%14.85%13.78%11.64%
Consumer Staples$62,398$67,923$73,4317.91%7.51%7.39%9.13%
Basic Materials$23,943$32,397$35,8133.04%3.58%3.60%3.31%
Consumer Discretionary$25,169$30,134$34,2403.19%3.33%3.44%3.84%
Industrial Products$16,627$22,041$25,9852.11%2.44%2.61%2.59%
Business Service$14,144$16,705$18,9691.79%1.85%1.91%2.46%
S&P 500$788,669$904,504$993,954100.00%100.00%100.00%100.00%

P/E Ratios

  • Trading at 14.84x 2010, 12.94x 2011 earnings, or earnings yields of 6.73% and 7.73%, respectively. P/E for 2012 at 11.77x or earnings yield of 8.45%. P/E’s significantly higher than a month ago, but still low relative to history and interest rates.
  • Earnings Yields still attractive relative to 10-year T-Note rate of 2.05%.
  • Autos only sector with single-digit P/E for both years. Energy and Finance also have single-digit P/E’s based on 2012 earnings.
  • Construction has highest P/E for all three years by wide margin.
  • S&P 500 earned $56.80 in 2009 rising to $83.18 in 2010. Currently expected to earn $95.39 in 2011 and $104.87 for 2012.


P/E Ratios
Oils and Energy21.2514.1210.149.95
Basic Materials25.2916.1811.9510.81
Industrial Products24.9018.2413.7611.67
Computer and Tech24.0416.3413.2912.21
Consumer Discretionary21.9717.8414.9013.12
Consumer Staples19.1217.1315.7314.55
Business Service23.0920.3217.2115.15
S&P 50021.7314.8412.9411.77

Data in this report, unless stated otherwise, is through the close on Thursday 12/08/2011.

We use the convention of referring to the next full fiscal year to be completed as 2011, not all firms are on December fiscal years, this can cause discontinuities in the data. The data is based on FY1, not based on 2011, even though I may call it 2011 in the report. All numbers, including historical ones, reflect the current composition of the S&P 500, thus some historical numbers may differ from those reported by S&P which are based on the composition of the index at the time of the reports.

Dirk van Dijk, CFA is the Chief Equity Strategist for With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market beating Zacks Strategic Investor service.

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