Zacks Earnings Trends Highlights: AK Steel, Dow Chemical, United Health and Valero

CHICAGO, May 24, 2011 /PRNewswire/ -- Zacks Research Equity Strategist, Dirk Van Dijk says that S&P 500 earnings are continuing to show red ink. He tracks companies on the Zacks.com web site, naming names, while forecasting trends for the months ahead.  

Earnings Are Great, But…

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The expectations for the full year are very healthy, with total net income for 2010 rising to $794.9 billion in 2010, up from $545.6 billion in 2009. In 2011, the total net income for the S&P 500 should be $911.9 billion, or increases of 45.7% and 14.7%, respectively.

The expectation is for 2012 to have total net income passing the $1 Trillion mark to $1.043 Trillion. That will also put the "EPS" for the S&P 500 over the $100 "per share" level for the first time at $109.32. That is up from $57.12 for 2009, $83.10 for 2010, and $96.82 for 2011.

In an environment where the 10 year T-note is yielding 3.18%, a P/E of 16.2x based on 2010 and 14.1x based on 2011 earnings looks attractive. The P/E based on 2012 earnings is 12.3x.

Analysts Raising Estimates

The analysts have responded to the better-than-expected earnings for the first quarter by raising their estimates for 2011. That's not particularly shocking, as the first quarter is, after all, part of 2011, so if they did not increase in response to a positive surprise, they would implicitly be cutting their estimates for the remaining three quarters of the year.

Still, the flood of estimate increases is impressive, with the revisions ratio sitting at 1.89. Total estimate revisions activity is near its seasonal peak. Thus over the next month or so, changes in the revisions ratio will be driven more by old estimates falling out of the four-week moving totals than by new estimate changes being made.

The estimate increases are widespread, with the ratio of firms with rising mean estimates to firms with falling estimates standing at 1.83. There is no "mechanical" reason for the estimates for 2012 to be rising. Those are even stronger than the ones for 2011.

The 2012 revisions ratio is now at 2.03, meaning that upwards estimate revisions are outpacing cuts by more than 2:1 for next year. The ratio of rising to falling mean estimates stands at 2.04. Those are extremely bullish readings.

Strong Fundamentals for the Market

This provides a strong fundamental backing for the market to continue to move higher. It is important to keep your eyes on the prize. There is lots of news out there, and much of it is more dramatic than earnings results, but rarely does it have more significance for your portfolio.

Earnings are -- and are going to remain -- the single most important thing for the stock market. Interest rates are an important, but distant, second.

Several Caveats
 
That does not mean that all is smooth sailing ahead. In a similar, but contrary nod to history, we are now at the softest part of the year (historically). There is a fair amount of truth to the old adage "Sell in May, but remember to return by November." Since 1945, the gain on the S&P 500 has averaged 6.8% (ex-dividends) from November through April, but only 1.3% from May through October.

The biggest threat to the market is if the debt ceiling is not raised by the beginning of August. If it looks like it will not happen, watch out. The Government of the United States defaulting on its debt is likely to have a somewhat larger impact on the markets and the economy than the impact of Lehman Brothers defaulting on its debts. The nation would be shoved right back into recession, and one deeper than the one that followed the Lehman collapse.

If that happens, then corporate profits would also collapse. However, when push comes to shove, I find it hard to believe that Congress would let that happen. While not the most likely case, the chance of no increase by the time the ceiling is hit is a very real possibility. Given the disastrous potential consequences, taking out some insurance in the form of deep out of the money puts would make a lot of sense at this point.

Government Spending Lower

We are already feeling the impact from lower government spending. First quarter GDP growth came in at just 1.8%, down from 3.1% in the fourth quarter. Total government spending was a drag of 1.09 points, up from being a 0.34 point drag in the fourth quarter. In other words, 0.75 of the total 130 point growth slowdown (57.8%) was due to increased austerity in Government spending.

In the third quarter, government spending contributed 0.79 points of the 2.60% total growth. The lower growth will result in lower tax collections, so the impact on the budget deficit will be much less than the amount advertised.

Unemployment Picture

The unemployment rate bounced back up to 9.0% nationally, despite the fact that it fell in 39 states in April. This was not due to, as many assume, people coming back into the labor force. It was due to the fact that the unemployment rate is derived from a separate survey from the one that measures the number of jobs gained or lost. The civilian participation rate has been stuck at the same low 64.2% level since January.

Given that the unemployment rate has been higher than that in just 6.17% of the months since 1960, one might expect that bringing down unemployment would be top of the agenda at both the Fed and on Capitol Hill. However, at Bernanke's recent press conference, the focus was mostly on inflation. The rate of headline inflation has been moving higher, but it is only up 3.2% over the last year. That is lower than what we have experienced for most of the last 40 years.

Commodity Prices

Furthermore, commodity prices have just fallen sharply, so we might start to see some relief very soon. Core inflation remains very low, up just 1.3% over the last year. This fear of phantom inflation is keeping further monetary easing off the table for bringing down unemployment. Because of the deficit, fiscal policy is also off the table, even though those who seem to scream loudest about it are unwilling to raise an extra nickel of tax revenue.

International Scene

The international situation clearly has the potential to abort the recovery as well. The disaster in Japan will clearly slow its economy dramatically in the second quarter, although much of that growth will be made up later in the year as the reconstruction process gets underway. Many U.S.-made products have parts which are made in Japan and that is likely to disrupt production here.

Factory output fell 0.4%, the first decline after 9 months of increases largely due to auto plants shut down for the lack of parts. The debt crisis in Europe is not going away, with Portugal now also getting bailed out, even as the ECB makes life tougher on the PIIGS by raising rates. Rates for the Greek, Irish and Portuguese debt are substantially higher than when the crisis first started.

It is clear now that at least Greece will be forced to restructure (aka partially default) its debt. The austerity campaigns have weakened those economies and undermined tax revenues, and so the bailouts have not made the situation much better.

Domestic Housing

Here at home, the housing situation has not been showing many signs of improvement, and I doubt we will see much in the housing related numbers due out this week. Note that the Construction sector is the weakest in terms of both surprises and estimate revisions.

In Conclusion

On balance I remain bullish, and I think we will end the year with the S&P 500 north of 1400, but that does not mean we will have a smooth ride between here and there. Strong earnings are trumping a dicey international situation, and the drama in DC. However, be prepared to move to the exits (or have some put protection in place) if it looks like the debt ceiling will not be raised.

As far as individual stock picks are concerned, look for the combination of a Zacks #1 Rank, with moderate P/Es and a reasonable dividend yield. The current issue of Earnings Trends has a list of the firms with the largest positive revisions for this year.

The best hunting ground for such firms seems to be in the Industrial, Materials and Energy sectors, but things are not limited to that sector. Some of the names to consider among the S&P 500 include AK Steel (NYSE: AKS), Dow Chemical (NYSE: DOW), United Health (NYSE: UNH) and Valero (NYSE: VLO).

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Contact: Dirk Van Dijk, CFA
Company: Zacks.com
Phone: 312-265-9211
Email: [email protected]
Visit: www.zacks.com

SOURCE Zacks Investment Research, Inc.