Earnings Season: Most Wonderful Time of the Year

NEW YORK (TheStreet) -- The fourth quarter 2010 earnings reporting season kicks off this week. Four times a year investors focus on the most fundamental driver of investment performance: earnings. As you can see in chart 1 below, the performance of the S&P 500 and analysts' revisions to their earnings per share (EPS) estimates are closely linked.

For the S&P 500 companies as a whole, the consensus of analysts' estimates point to average earnings per share growth of 29% from one year ago. Earnings have grown at five times the pace of sales over the past year. Widening profit margins have helped earnings outpace sales growth. While the job market has been slow to improve (as evidenced by the soft employment report for December), that dark cloud presents a silver lining in the form of low labor costs for businesses and thus higher profits.

On average, labor expenses make up about 70% of the cost of producing goods and services in the United States. The labor cost per unit of output has been falling at an unprecedented 4-5% pace, according to the Bureau of Labor Statistics. In addition, reduced interest and tax expenses are contributing to companies' bottom lines. Businesses have reduced and refinanced a tremendous amount of debt over the past year. In addition, they have a significant amount of tax-loss carry forwards made available to them by tax law changes that they are now using to minimize taxes.

The S&P 500 EPS for the quarter may set a record as the highest fourth quarter EPS in history, and among the top three quarters in history - behind only the first two quarters of 2007. Having climbed back to near the prior peak, earnings growth is beginning to slow. We except closer-to-normal EPS growth of 10% in 2011 after 2010 resulted in a strong 39% gain over 2009.

Our outlook for 2011 corporate profits is bound, in part, by continued sluggish revenue growth resulting from modest economic expansion in the developed markets, including the United States. While companies have been producing strong double-digit earnings gains on the back of single-digit revenue growth coupled with significant cost reductions over recent quarters, further gains are limited. There is little room to squeeze out additional expenses in 2011 particularly given that costs associated with materials, energy, and expanding workforces are rising.

The wonderful time of the year that makes up the information-rich fourth quarter earnings season runs about four-to-six weeks starting about two weeks after the close of the quarter. During this earnings season we are paying special attention to business spending, dividends, and guidance from business leaders on the outlook for 2011.
  • Business Spending - While investor attention is often directed on consumer spending as a driver of profits, we will be watching business spending-driven industries more closely. Business spending and commodity prices are major drivers of S&P 500 profit growth while discretionary consumer spending has a much smaller contribution to the S&P 500. During the fourth quarter, commodity prices rose and manufacturing rebounded from the summer weakness, according to the ISM index (Institute for Supply Management Purchasing Managers Index), likely boosting profits for S&P 500 companies. We will be watching to see how effectively this translated into profits for the Information Technology, Industrial, Energy, and Materials companies for clues as to how rapidly their profit growth may slow in 2011.
  • Dividends - Near-record corporate earnings, strong cash flow, and pending government approvals for the Financials sector, are likely to lead many companies to announce substantial dividend increases in the coming weeks. In fact, dividends per share growth is likely to exceed earnings per share growth in 2011. In total, S&P 500 companies have amassed nearly $2.5 trillion of cash and short-term investments. Higher yields may begin to attract yield-hungry individual investors to the stock market.
  • Guidance - Analysts expect a record $96 in EPS in 2011 for S&P 500 companies, representing about 14% growth. We believe 10% growth is more likely for EPS in 2011 and expect downward guidance from business leaders in the coming weeks potentially leading to downward revisions to 2011 earnings by analysts and a modest pullback in stocks as the earnings season matures. The last two monthly employment reports show corporate America is unusually slow to hire new employees suggesting a cautious outlook that may also cause them to rein in growth forecasts. On the other hand, companies may see a modest boost from a new 100% tax write-off for capital expenditures passed late last year as part of the tax cut bill and taking effect January 1. We will be listening closely to conference calls and reading press releases to aid in assessing the likely movement in earnings expectations.
  • The earnings reporting season has historically had an impact on stock prices. Although the S&P 500 posted gains for 2010 as a whole, stocks were generally down during the four earnings reporting seasons in 2010. The performance of the stock market during the four earnings seasons in 2010 was flat-to-down, as measured by the S&P 500 index over the four weeks starting at the middle of the month following the end of the quarter. In 2010:
  • The mid-January through mid-February season coincided with a peak-to-trough 7% decline in the S&P 500.
  • The mid-April to mid-May season coincided with a decline of about 10%.
  • The mid-July to mid-August season coincided with a slight decline.
  • The mid-October to mid-November season coincided with a slight gain.
  • Given the combination of drivers this earnings-reporting season, combined with overbought market conditions, the upcoming earnings season could again contribute to a flat-to-down stock market. We suggest investors use any weakness as a buying opportunity, which may be capable of enhancing the modest single-digit gains we envision for the year as a whole.

    It is important to keep in mind that the companies that report early in the season are most often not the bellwethers they are commonly thought to be. We will not really know how results are shaping up until just after the end of the month when about half of the S&P 500 companies will have reported.
    TheStreet Tools
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    This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.

    Jeffrey is Chief Market Strategist and Executive Vice President at LPL Financial.

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