With so much attention on the midterm elections and the Fed recently, it’s easy to overlook the importance of corporate earnings, which have been surprisingly good. Despite the generally sluggish economy, out of the 90% of companies in the S&P 500 that have reported so far,76.7% have posted third quarter earnings that were better than last quarter, and 71% posted earnings that were higher than analysts expected. On average earnings for these companies were 32% higher than the third quarter of last year. Profit grew in every sector, but the strongest gains came from the financial, industrial and information technology companies.
The strong earnings growth in the third quarter is encouraging and shows the resiliency of companies that have cut costs to the bone and found ways to stay profitable in tough times. Still, it’s important to keep in mind that these companies benefit from easy comparisons to 2009. When you take out financial companies, which have larger growth in comparison to rock-bottom financial crisis levels of last year, earnings growth for the S&P 500 companies drops from 32% to 25.8. Companies have also benefited from exposure to emerging markets which are growing more rapidly. Growth in the domestic economy remains fairly weak.
Perhaps the most important thing to look at in earnings reports right now is sales. Much of the earnings growth has come from cost cutting, a strategy that is fine for now but is a temporary solution. Sales are a better indicator of how companies and the economy are doing. 62% of the S&P 500 companies have beaten sales estimates, which is good, but sales growth remains low. We will see more hiring only when sales increase. For now companies remain highly cautious with record levels of cash on their books. This suggests that as soon companies are convinced that the economic recovery has legs they are well equipped to spring into action and put all that cash to work through dividends, acquisitions, share buy-backs or other investments.
Third quarter earnings were impressive, though perhaps not quite as good as they seem at face value, but companies with their strong balance sheets are poised to take advantage of continued economic recovery in 2011.