Counting Candy (and Earnings)

As kids count their Halloween candy, we’re taking an equally tasty tally: Q3 earnings growth. More than halfway through Q3 earnings season, it’s safe to say we’re off with a bang. Of the 315 S&P 500 companies reporting thus far, 71% have beaten estimates, and earnings are up 16.3% overall.* If this keeps up, it’s likely Q3 will mark the eighth straight quarter of overall earnings growth, and corporate profits continue logging all-time highs.

Growth was broad-based, with 9 of 10 sectors showing positive growth thus far. Energy (+52.5%), Materials (32.6%) and Industrials (+19.9%) qualify as gangbusters, and even still-beleaguered Financials (+11.2%) boasted a double-digit gain. The only negative sector, Utilities, was just barely down at only -1.9%—but in a period when economic growth was better than many anticipated, we’re not surprised to see this classically defensive sector lag. And lest anyone attribute strong earnings growth to cost-cutting, corporate revenues are up 10% so far—making Q3 the eighth straight quarter of rising sales, with every sector anticipating full-quarter revenue growth.

In our view, that’s a dandy haul—and better than what many expected. Businesses remain highly profitable, and rising sales speak to increased activity, despite falling confidence and widespread fears of an economic slowdown. Add in last week’s personal consumption data (up 2.4% in Q3) and Q3’s GDP advance estimate (+2.5%), and it’s clear the economy is far stronger than many perceive. What’s more, sentiment being so detached from reality should provide a nice tailwind for markets heading into 2012.

Speaking of low sentiment, some have tried to spin positive earnings news into a negative, citing lowered Q4 expectations and suggesting it may signal an inflection point for stocks (given a similar percentage-point drop in expectations in April 2008). To which we say, look at the facts. Over the past month, Q4 aggregate earnings expectations were indeed cut a full 3.5 percentage points—from 20.2% to 16.7%. In other words, the forecast is still for growth—strong growth—just at a slower strong-growth pace. And if earnings do meet that now-lowered pace, it would still be a bit of an acceleration overall from Q3 (to date). Even if Q4 earnings come in a bit lower (or higher!), we don’t see any valid comparisons between today’s ongoing double-digit earnings growth and 2008.

In our view, pretty much all aspects of the Q3 earnings season suggest stocks remain undervalued. Firms remain relatively lean, consumer demand is growing and non-financial companies have over $2 trillion cash on hand—money they can funnel into expansion, research and development and the like—all of which should support revenue and profit growth going forward. Add to that the likelihood economic data continue surpassing expectations, and there’s a strong case for stocks to have a sweet 2012.

*Source: Thomson Reuters “This Week in Earnings,” October 28, 2011.