Third Quarter Earning Show Broad Economic Strengthening

By Daniel Indiviglio

Americans expressed a grim view of the economy during the third quarter. Consumer confidence fell in July, rose slightly in August, plummeted in September, but rose slightly in October. Yet GDP growth shows that the U.S. economy actually expanded modestly, by 2% during the quarter. A round-up of corporate earnings shows similar optimism: the negativity surrounding the U.S. business climate is largely a matter of perception and does not reflect reality.

Before getting into earnings data, a quick caveat is in order. Of course, unemployment is still terribly high, and that's what's driving much of the negative sentiment. But the economy is stuck in a vicious cycle where firms don't perceive enough demand to hire aggressively, while Americans aren't spending much because firms aren't hiring. For the recovery to ramp up, something would have to give. Perhaps if Americans understood that the economy is actually poised to do quite well going forward, the vast majority of people, who have jobs, wouldn't be as stingy, and the recovery could flourish.

That recovery appeared to be growing stronger in the second quarter, but it felt like the economy took a step back in the third. It didn't. The one obviously bad sector was residential real estate, but its woes were mostly caused due to the distortion of the buyer credit's expiration towards the end of the second quarter. Corporations did quite well.

Earnings

An earnings roundup for the third quarter results we have so far shows this very clearly. First, let's consider earnings. Here's a chart comparing the corporate earnings of the 376 firms in the S&P 500 that have reported so far. The drawback of this analysis is that it only considers those firms, so doesn't necessarily indicate that smaller corporations or smaller businesses are also faring as well.

eps 2010-Q3.png

The first set of columns is arguably the most important. It shows just how briskly earnings have been growing. They have averaged an impressive 36.9% growth rate so far for the firms that have reported. At this point, that looks even stronger than in Q2, and will vastly improve upon what these firms reported a year earlier.

Moreover, at this point, the portion of firms experiencing positive earnings growth is slightly higher for the third quarter than it was in the second. Of course, both are much higher than they were in the third quarter of 2009. Expectations are a little less important here, since they don't tell us anything about the health of the economy, but you can see that analysts are being consistently being pleasantly surprised by earnings.

Revenue

Earnings can be tricky. Firms could merely be cutting costs to boost profits, while revenue could be weak. That wouldn't indicate a strong economy -- just firms doing what they must to survive. But revenue also looked pretty good last quarter. Here's a similar chart based on revenue, instead of earnings:

revenue 2010-q3.png

First, you can see that growth here is much lower, but it's still relatively strong at 10.3% compared to a quarter and year earlier. Firms are showing more revenue, but a lot of the earnings growth is also coming from cutting costs.

The second set of columns is also tells a very good story. More firms are reporting positive revenue, accounting for a whopping 81.7% of the index. That's better than the second quarter, and vastly improves upon the third quarter of 2009. Again, the same portion of firms is pretty steadily beating expectations.

So what does it all mean? Although these results are preliminary with some firms still needing to report, a strong majority of the largest corporations in the U.S. appear quite healthy from both an earnings and a revenue perspective. That likely means the only thing preventing these firms from hiring more aggressively is their expectation that consumer demand will remain weak in the near-term. And ironically, that consumer demand is partially weak because it anticipates that firms aren't doing so well, which this analysis helps to show is not the case -- at least for the biggest corporations in the U.S.

Note: The averages above for EPS and revenue are weighted by market cap.

This article available online at:

http://www.theatlantic.com/business/archive/2010/11/third-quarter-earning-show-broad-economic-strengthening/66005/