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November 16, 2009 Third Quarter Earnings Review

At around 1100, the S&P 500 index is in line with its high of the year. Signs that the recovery in the economy and earnings are sustainable are encouraging investors to drive stocks higher. The key sign of sustainability is job growth, and the key to job growth is profit growth.

In our Third Quarter Earnings Preview published on October 5, we stated that we were looking for four trends during the upcoming earnings-reporting season: revenue growth, a record-breaking percentage of companies beating estimates, a rise in the outlook for fourth quarter earnings, and a narrowing in the range of 2010 estimates. With nearly all of the results in for the third quarter, we are pleased to see the season delivered on all four trends.

1. We expected to see better top-line growth in the third quarter compared to the second quarter. While down about 10% from a year ago, revenues did rise sequentially from the second quarter. 58% of companies reported sales above analyst expectations.

2. We believed analysts’ estimates for the quarter were too low given the improvement in our Current Conditions Index relative to the falling estimates for earnings during the quarter. Therefore, we hoped to see most companies exceed expectations in the third quarter by another record-breaking margin similar to the second quarter when over 72% of companies exceeded the average consensus estimate. As it turns out, an astounding 80% of companies exceeded estimates in the third quarter — a record that may stand for a long time. The consensus S&P 500 earnings per share expectation for the third quarter went from $14.65 at the start of the reporting season, to $16.51 after most companies had reported. The strongest results relative to expectations were in the Information Technology, Consumer Discretionary, and Materials sectors. In aggregate, S&P 500 companies posted about a 25% annualized increase in earnings from the second to the third quarter.

3. We hoped to see the analyst expectation rise for the fourth quarter. The consensus estimate for fourth quarter earnings was $16.27 before the reporting season got underway — it is now $16.96.

4. We were less concerned about estimates for 2010 moving up; we instead hoped to see increased confidence in the 25% consensus gain. We measure this by a narrowing of the range between the analysts’ high and low estimates for 2010. While still wide by historical standards, the range did narrow by about $2 per share as the low-end moved up by $2.50, and the high-end rose by $0.50. The consensus earnings per share estimate for 2010 is about $76 – $77. Earnings are expected to be strongest in the first half of 2010, an easy comparisons to early 2009, with the first quarter expected to post a growth rate of 38%.

The rebound in corporate earnings is very important to the economic recovery. Conditions for consumers are poor as evidenced by surveys, job losses, and weak income growth. However, corporate profits have accelerated at a record-breaking pace since the fourth quarter of 2008. While consumers face a heavy debt burden, businesses generally have good balance sheets with low debt and high cash balances. Profits have been boosted by cost cutting on everything including employment, advertising, capital spending, travel, and inventories. The aggressive cost cutting in corporate America has led to a profit-driven economic recovery. As earnings rebound, businesses are looking to reinvest in growth. We expect this renewed pace of business spending to lead to job growth by early next year, helping to sustain the recovery in the economy and markets into early 2010.

Investing in international and emerging markets may entail additional risks such as currency fluctuation and political instability. Investing in small-cap stocks includes specific risks such as greater volatility and potentially less liquidity.

Stock investing involves risk including loss of principal Past performance is not a guarantee of future results.

Small-cap stocks may be subject to higher degree of risk than more established companies’ securities. The illiquidity of the small-cap market may adversely affect the value of these investments.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rate rise and are subject to availability and change in price.

© LPL Financial

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