Are Expectations Too High?
Fourth quarter earnings season is underway. The pre-announcement period was one of the most positive in recent history. The negative / positive ratio was only 1.3 compared to 1.6 last year and 1.6 for the third quarter. The S&P 500 was even more positive as just two more companies announced earnings would be below rather than above forecasts for a pre-announcement ratio of 1.0. I cannot remember a ratio that low for the S&P 500. Year-over-year earnings growth estimates for the fourth quarter have moved up a notch since the end of 2003 to 22.1% from 21.8%. First quarter growth forecasts have been bumped up by 0.1% to 12.8%. Most of the first quarter revisions will happen as companies update their guidance for analysts over the next couple of weeks. Of the 45 S&P 500 companies that have already reported fourth quarter results, 28 companies earned more than predicted and only 5 reported less than expected.
Overall fourth quarter earnings have been good, but the first big day of earnings disappointed investors. At least until the market opens Thursday. Wednesday night Intel, Apple and Yahoo! reported earnings. Despite earning more than analysts forecasted, all three traded down in after-hours trading. Intel reported record quarterly revenues along with an impressive 63.3% gross margin. Looking ahead to the first quarter, Intel expects revenue to decline approximately 6% sequentially which will push gross margins down to around 62%. These two factors appear to be the cause for investors' apprehension. The company also reported that it capital expenditure budget would be between $3.6 billion and $4.0 billion for 2004, which compares to $3.7 billion in 2003. Several analysts were hoping the $4.0 billion level would be the low end of the range instead of the higher end.
Over the past several quarters, investors have been rewarded as companies met or beat analysts, earnings estimates and guided future results higher. Naturally, investors have come to expect that guidance would be raised for the next quarter. Since the stock market is a game of expectations, results could be good, but not good enough. Valuations remain extremely expensive, which magnifies any errors if expectations are not realized. The technology sector seems most prone to disappointing investors. Business conditions have improved remarkably from a year ago, but investors' expectations have grown even more. Perhaps the earnings from Intel, Apple and Yahoo! will cause investors to reevaluate the valuations placed on technology stocks.
One anecdote depicting the increased level of enthusiasm in the technology sector comes from the Consumer Electronic Show (CES) that was held last week. I'll just let them pat themselves on the back. This is from their press release:
"The 2004 International CES set records across the board with 129,328 technology executives visiting 2,491 companies in 1.38 million net square feet of exhibit space. Final attendance numbers will be posted this spring after review by a third-party auditor. By comparison, the 2003 International CES had 117,704 attendees and 2,230 companies in 1.25 million net square feet of exhibit space."
Investors have also embraced the homebuilding sector. After an almost straight run up, the stocks have gotten more volatile. Since the end of November, the S&P 500 Homebuilder has experienced three moves of 10% (two down and one up). The volatility started after Hovnanian said that 2004 would be "weighted a bit toward the back half of the year." On the conference call, the company added that, "we are not comfortable, I repeat not comfortable with the current analyst consensus estimate of $2 per share for our first quarter of 2004." Last week, The Ryland Group, one of the largest homebuilding companies, reported that orders in the fourth quarter dropped by 8.9% versus the fourth quarter last year. Other homebuilders have reported results that have been similar to prior results; record orders, record backlogs, etc. But for the first time there is staring to be some differentiation between companies. The question now is whether some companies are starting to fail operationally or if it is marking a turn in the market.
Homebuilding activity continues at a very high level. Purchases applications increased 11% for the week ending January 9, only 3% from the all-time high set in May last year. The refinancing index also got a boost of 25% and back above 2000 for the first time in four weeks. It's likely this will increase next week as well since interest rates dropped on Friday after the employment situation report. Last Wednesday, 30-year mortgages averaged 5.81%. That has dropped 25 basis points to 5.56% in just the past seven days. It's likely that the homebuilders will have good results this year, but will see their stock price drop as investors have placed unrealistic expectations on the industry, although the industry is doing its fair share of building up expectations.
The auto incentive war heated back up this month. Last week, DaimlerChrysler announced it would offer 48-month zero-percent financing plus $2,000 cash rebate on nearly its entire line of vehicles. Following that announcement GM added SUVs and pickup trucks to the list of vehicles eligible for zero-percent financing for five years. This week, Ford sweetened its pool of incentives as well. Among others, the company extended the terms for zero-percent financing to 60 months on the older model F-150 and added $500 in rebates on the Expedition and Excursion. Trucks and SUVs are the major source of profits for the domestic automakers. The Japanese automakers are finally competing in the full-size truck market. This will likely crimp profits as the domestics have to fight back by lowering prices. And now we are seeing it.
One news story that probably got lost with everyone focused on earnings was a study conducted by the Henry J. Kaiser Family Foundation and Hewitt Associates. According the study retirees will be left shouldering much of the increase in healthcare costs. Ten percent of respondents said they terminated benefits for future retirees last year and one in five companies may eliminate it in the next three years. Additionally, 71% said they passed a larger share of the premium to retirees and 86% anticipated doing it over the next three years. Not only have the costs increased, but a lot of companies face a huge under-funded plan. While under-funded pensions have garnered attention, post-retirement benefits have not attracted the same attention from analysts. In many cases the funding gap for these benefits outweigh those of the pension. At the end of 2002, General Motors' pension was under funded by $19.3 billion. The company made front page news by issuing debt to fund the obligation. However, its health benefits plan was under-funded by $51.4 billion. Its obligations were $57.2 billion with assets of only $5.8 billion.
Most market pundits have predicted that the market will consolidate during earnings season before resuming the 10-month long rally. Furthermore, most expect the market to run into trouble starting the second half of the year. With expectations high and valuations even higher, investors could be in for a surprise.