Sunday, 13 January 2008

Attention on US earnings

Fourth quarter earnings season kicks into full swing in the US this week. The latest estimates from Standard and Poors suggest 4Q08 operating earnings will show a decline of about -8.2%. Companies of interest include Citigroup (C), Merrill Lynch (MER), J.P. Morgan Chase (JPM), Washington Mutual (WM), PNC Financial (PNC), Wells Fargo Co. (WFC), General Electric (GE), IBM (IBM) and Intel (INTC).

The market is fully expecting a poor earnings season, particularly from financials. Huge multi-billion dollar writedowns from the likes of Citi and Merrill will also come as no surprise.

Of more interest will be company forecasts for 2008. Especially companies in sectors that have been largely immune from the problems in housing, financials and retail. The market was spooked last week by AT&T's admission about a softening consumer. Unexpected comments both positive and negative have the potential to move the markets which are already teetering on a knife edge.

I have been saying for many months that analysts estimates are too high and they have started to come down in recent months. If 4Q07 earnings come in as expected FY07 earnings will actually be slightly negative. Looking out, 1Q08 and 2Q08 estimates have come in slightly from before Christmas to +4.4% and +4.2% respectively. That's largely because their comps (comparable periods from the previous year) are pre credit market turmoil.

When you get to 3Q08 the comps become much easier because 3Q07 was when earnings fell off a cliff. What that tells you is that analysts expect things to get back to normal. This is what gives me more confidence in my recession call. Company analysts, just like economists, are behind the curve in their expectations. Major segments of the mortgage and securitzation markets have just gone away and with them, a lot of profits for financial institutions.

Forget about the huge writedowns from Merrill and Citi and focus on the health of their remaining businesses. Also watch the bad debt provisions for the likes of WM who have already signaled massive increases. This will effectively wipe out their profits for the year.

But as alluded to above the biggest surprises will be the ones that are the least expected. In this increasingly uncertain environment you should be expecting the unexpected (if that's possible). Note that the unexpected does not have to be all negative, plenty of companies will beat forecasts and raise expectations, however you should also be prepared for plenty of negative surprises.