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    MARKET EDGES

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Takeaway: While the current earnings season has been cause for worry, pollyannaish estimates remain the key headwind to the stock market from here.

SUMMARY BULLETS:

  • Roughly 80% though earnings season, it’s clear to see that 3Q12 has shaped up exactly as we had laid out in our #EarningsSlowing theme: very bad.
  • Consensus remains out to lunch with their forward revenue, operating margin and EPS growth estimates. When you combine the negative trend in corporate guidance with the potentially-precarious Global Macro setup (potential US recession; no Chinese stimulus; Europe continues to contract), it’s easy to anticipate a scenario whereby those estimates have to be revised down hard and fast at some point over the intermediate term.
  • Aggressive estimates for operating margin expansion puts a great deal of pressure on corporate management teams to accelerate material cost-cutting initiatives like we’ve seen at UBS, DOW, AMD, RIO, FDX and CMI (to name a few). While that may appear good for a single company’s earnings outlook in the short term, the reality is that when corporations are engaged in cost-cutting en masse, GDP growth tends to slow materially; this perpetuates top line weakness across the corporate sector in a reflexive manner.

For the 3Q12 earnings season to-date, 59.8% of S&P 500 companies have missed on the top line and 28.7% have missed on the bottom line (388 total). That compares with 57.8% and 26.8%, respectively, in 2Q12. Average SPX constituent EPS growth is flat on a YoY basis and average sales growth is down -1.4% YoY. We have not seen weakness like this since mid-to-late 2009.

From a forward-looking perspective, 74 companies have issued 4Q12 EPS guidance and 56 of those cases have been below the mean EPS estimate (vs. 18 above). Per Factset, the 76% negative guidance ratio is well above the long-term average of 61%, though roughly in-line with the 78% recorded at this time during the previous quarter.

We know consensus is typically poor at forecasting inflections in macro, but it’s shocking to us that consensus continues to aggressively ignore the warnings issued at the micro level. As the chart below highlights, the sell-side continues to expect a v-bottom and a demonstrable acceleration of revenue and EPS growth over the NTM.

A QUICK PEAK UNDERNEATH THE HOOD OF THE US EQUITY MARKET - EARNINGS SEASON 2.0

When you combine the negative trend in corporate guidance with the potentially-precarious Global Macro setup (potential US recession; no Chinese stimulus; Europe continues to contract), it’s easy to anticipate a scenario whereby those estimates have to be revised down hard and fast at some point over the intermediate term. We can’t see how that is a positive catalyst for the stock market, but we’ve been surprised before.

Digging into the weeds a bit, we see that consensus continues to burden corporate management teams with incredibly aggressive margin expansion assumptions. Over the NTM, SPX constituent operating margins are projected to expand by an average of +101bps YoY per quarter on a median basis. That compares with +5bps of median YoY expansion in 3Q12 and an average of -2bps YoY over the LTM.

A QUICK PEAK UNDERNEATH THE HOOD OF THE US EQUITY MARKET - SPX Margins

Judging by the latter trend, it would appear that much of the earnings “juice” has been squeezed from corporate operations. Moreover, consensus forecasts NTM median SPX constituent revenue growth of +3.8% YoY on average, per quarter, which does not bode well for meeting their aggressive operating margin assumptions.

A QUICK PEAK UNDERNEATH THE HOOD OF THE US EQUITY MARKET - SPX Revenues

That setup puts a great deal of pressure on corporate management teams to accelerate material cost-cutting initiatives like we’ve seen at UBS, DOW, AMD, RIO, FDX and CMI (to name a few). While that may appear good for a single company’s earnings outlook in the short term, the reality is that when corporations are engaged in cost-cutting en masse, GDP growth tends to slow materially; this perpetuates top line weakness across the corporate sector in a reflexive manner. Refer to our OCT 10 note titled, “#EARNINGS SLOWING UPDATE: IS CORPORATE COST-CUTTING COMING BACK WITH A VENGEANCE?” for more details.

Broadly speaking, praying for stock buybacks is not a risk management process.

Darius Dale

Senior Analyst