S&P 500 Very Overbought, But Earnings Remain A Good Story

According to ThomsonReuters, the “forward 4-quarter” estimate for the S&P 500 slipped $0.21 this past week to $118.54, and just $0.50 from the all-time record high print of $119.04 from the first week of October.

• The P/E ratio on the forward estimate is now 14.8(x).
• The “earnings yield” using the forward estimate is now 6.74%.
• The “forward 4-quarter” growth rate jumped to 6.66% from last week’s 6.19% but still shy of the 7.30% peak in mid-September.

For Q3 ’13, the overall rate of growth (per Thomson) came in at +3.3%, but if the JP Morgan (JPM) charge is excluded, the overall growth rate for Q3 ’13 earnings is +5.9%.

When we started the quarter, because we are lapping the weakest quarter of earnings growth post the 2008 – 2009 Recession, I thought the S&P 500 could generate 7% – 8% y/y growth, which seemed very far fetched at the time, but looks more achievable now given that the benchmark is already at 5.9% with a big chunk of the S&P 500 set to report again this week.

Roughly half of the S&P 500 has reported and 68% of those reporting have beaten EPS estimates, while 54% have beaten revenue estimates. This is better than last week’s upside / downside surprise ratio.

JPM’s legal charge in the 3rd quarter report, represents the biggest drag for both the Financial sector and the S&P 500 as a whole. Per Factset, “if JPM is excluded from the index, the (y/y) growth rate for the Financial sector would improve to 15%, while the growth rate for the SP would rise to 4.9%”.

One of the reasons we remain overweight Financials for clients is earnings growth: the Financial sector started the October quarter expecting 10% y/y earnings growth, and excluding JPM is now 15%. For q4 ’13, the y/y growth expected for Financials is +25% (using Thomson data) which has remained fairly steady all year. Q4 ’13 could, and likely will, be impacted by all these legal settlements that are in the headlines every day, but Financials offer good relative value when looking at earnings growth versus multiples across the S&P 500.

Technology earnings are seeing the most upside surprises which is another sector that offers good relative value, given the cash-flow valuations. Apple (AAPL) reports Monday night after the bell, and remains the biggest drag on technology sector earnings, after being the biggest positive contributor to technology up until Q3 ’12. According to Facstset, if AAPL were excluded from Q3 ’13 Technology earnings, the y/y growth rate for the sector would be +11%, second only to Financials +15%, ex-JP Morgan.

Personally, I think AAPL will report a decent 3rd quarter, and have a very strong holiday season, although we question the long-term growth prospects of the brand. AAPL might be faced with the next few years containing 3% – 5% earnings growth, but we will see what the estimates hold after the fiscal Q4 ’13 report on Monday, and then the Q1 ’14 report in January ’14. (We added to the stock this week, after the breakout above $513, the August ’13 high.)

Technology has a whopping 84% “beat” rate on Q3 ’13 earnings per Thomson. 5% of tech companies have matched estimates and 11% have missed. This is the best showing of any sector.

Sector Surprise: Basic Materials started the quarter expecting flat y/y growth but estimates have risen to +7% in just three weeks. Technically the stocks have acted well since late June, and after a disastrous and horrid 2nd quarter 2013 earnings season for the sector. Forward estimates may have gotten too pessimistic and too low. 70% of the sector is Chemicals, so DuPont’s (DD) spinoff news last week may have impacted estimates, as did the good earnings reports out of Freeport (FCX) and Alcoa (AA). US Steel (X) reports this week, and if the trend holds, the company should report an upside surprise. Technically, X needs to trade above $24 – $26 to break out again.

Sector with the Lowest Expectations: Without question, the sector with the lowest expectations is Energy. At roughly 11% of the S&P 500 by market cap, Thomson is looking for a decline in revenues of 5.5% y/y, with y/y earnings growth expecetd to come in at -7.9%, down from expected -0.7% on October 1. Sector analysts have been cutting numbers on the sector pretty harshly, which sometimes happens near sector bottoms. The slow bleeding in the price of crude can’t be helping. On our spreadsheets, both Chevron (CVX) and Exxon (XOM) face easier comp’s in 2H ’13 then 2014, after sharp downside surprises in Q2 ’13. Some think crude oil will drop into the high $80′s, which is another 10% decline. There are a host of energy companies reporting this week, so we will get a look at the sector results by Friday.

2014 expectations: According to Thomson, the expected 2014 earnings growth rate remains stable at 11%, but calculating our “forward 4-quarter” growth rate, the result is lower as of Friday, by 4.5%. We need to see that forward growth rate start to work higher if the 11% growth rate being expected by the sector earnings estimates is to be realized. Frankly, if we get 10% earnings growth in 2014, I’d be happy, (with the rationale to come later).

Conclusion: S&P 500 earnings continue to tell a positive story. Technology was the big surprise this past week (Amazon (AMZN), Google (GOOG), Microsoft (MSFT) all with strong upside, and we are long all 3) and the numbers are starting to reflect the optimism around the sector, which offer attractive valuations as well. If Washington can stay out of the press, I think the S&P 500 can grow earnings in 2014 by 10%, which wouldn’t be that big of an improvement from the 6% – 7% (operating growth) we are likely to see for 2013, when the year concludes by mid-February.

At 14(x) forward earnings, the S&P 500 remains fairly valued given the 10-year average P/E ratio on the S&P 500 (per Factset) and certainly not as stretched as some in the financial media would lead you to believe. In addition, the quality of earnings (in my opinion) is better. What you don't hear is that the S&P 500 is trading at 9(x) – 10(x) cash-flow, which adds to the quality of earnings.

The S&P 500 remains overbought and extended, but a 2% – 3% pullback would be perfect, and might take some of the excitement out of the market. AAII data has gotten too bullish.