Once again corporate earnings have surprised to the upside in the U.S. for the third quarter of 2011 as 72% of the S&P500 companies have beaten earnings expectations, in line with the prior quarter but still comfortably above normal levels.    Financials remain relative laggards, with just 64% topping the consensus view and an outsized 34% missing the mark. But before we declare the Q3 season a complete success, we acknowledge that negative preannouncements for Q4 are running well above normal levels (3.4-to-1 negative versus positive).  Also, after an abnormally high share of U.S. companies have been issuing above consensus guidance for about 2 years, the net percentage now doing so has drifted back down to normal levels (see Chart below).

Companies only Neutral on Guidance

Companies appear to be scaling back their outlooks amid economic uncertainty, and forward earnings expectations will probably need to be adjusted somewhat lower as the very strong momentum in corporate profits seen earlier in the recovery began begins to fade.  However, many companies are just being prudent, recognizing first of all that there is economic uncertainty in the outlook and that they need not forecast on the basis of the most optimistic assumptions.  They have probably also noticed that stocks get hit much harder for missing earnings expectations than they rise after beating expectations, so that there is very little incentive to issue bullish outlooks.  Management credibility also gets hit harder from an earnings miss and that negatively impacts valuations.

In terms of current stock market valuations, the S&P 500 earnings yield sits way up at 7.9% despite the rally in stocks since the end of September. That’s a 5.8 point spread over 10-year government bonds, versus an average of about 1.6 points over the past ten years. In other words, all else equal, forward-year earnings expectations could be cut by over 30% and the earnings yield-bond yield spread would only just be back in line with recent norms.  When expectations get this low, it is much easier for companies to do better than expected and often coincides with stock market bottoms.

Looking at aggregate corporate profits margins, the picture continues to be exceptionally good as shown in the chart below.  While the trend in profit margins has been rising since the early 1980’s, the series of data has clearly been volatile, with margins swinging wildly during periods of recession and recovery.  Lower labour costs and increased levels of productivity have been the key drivers of margin growth, but there has also been more of a focus by most corporations in having stronger gross and net profit margins by keeping inventories low, increasing the outsourcing of business functions and better management of corporate balance sheets.

Volatile Profit Margins Holding Near All-Time Highs in U.S.

While margins will probably slip somewhat from the current record levels with somewhat lower economic growth and higher input costs, the profit picture nonetheless continues to be exceptionally strong.  Combining strong profitability with low stock valuations and low interest rates makes a compelling case for stocks at these levels in our view.  Moreover, the fact that investor sentiment is generally so bearish suggests that stocks could experience a sharp move to the upside driven by momentum alone.

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