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VERSACE: Can the second quarter keep up the pace?

- - Thursday, April 5, 2012

ANALYSIS/OPINION:

Last week brought the first quarter of 2012 to a close and with it some heady stock market returns, as measured by all three of the major market indices. The Dow Jones Industrial Average returned 8 percent for the quarter, which was tame compared to the 12 percent return for the S&P 500 and more than 18.5 percent jump in the Nasdaq for the same period.

Impressive results and the strongest performance for the first calendar quarter since 1998. As always, the question is whether that strength will continue, and if not, what are we likely in for next?

Early this week, we learned that not only did eurozone unemployment rise to the highest level in more than 14 years in February, but manufacturing in the region contracted for an eighth consecutive month. Taken together, these two data points are the latest proof points for what more than a few people have suspected in recent months: The eurozone economy has likely slipped into a recession in the first quarter.

The February data are coming from the European Union's statistics office in Luxembourg, but other data sources, such as Markit Economics, point to further erosion in March. More specifically, Markit's manufacturing gauge for the 17 euro countries dropped to a three-month low in March. Breaking down the data, we see the German indicator fell to 48.4 from 50.2 the previous month, while in France the number slipped to 46.7 from 50; this shows the manufacturing malaise is spreading to the core of the eurozone.

Looking east, there seems to be some conflicting views on China, as the official Purchasing Managers' Index hit an 11-month high with a stronger-than-expected reading of 53.1 for March, but a separate private survey by HSBC painted a weaker picture. HSBC's findings showed the index reading for March coming in at 48.3, well below the 50 mark separating growth from contraction.

Taken together, these conflicting indicators suggest that China remains sluggish and concerns for a landing — hard or soft — remain. Factory activity also slowed in India, Asia's third largest economy, during March, while inflation picked up in February for the first time in five months.

Not only have we all heard about the year-to-date rise in domestic gas prices, but most, if not all, of us have felt the pain at the pump. While we tend to think of how this affects our own pockets, we have to remember the rise in fuel prices and the ripple effect it has on food and other consumable prices is also felt by companies and other institutions.

Warnings from General Mills and ConAgra Foods that, despite the outlook for better revenues, profits would be under pressure in 2012 due to higher input costs support this view. A growing concern I have is what this means in the few weeks as companies not only report their first-quarter results but also update their outlooks for 2012. Odds are that few companies expected such a rise in their input costs back in January when they issued their original forecasts.

Ahead of April's corporate earning reports, expectations for the S&P 500's operating earnings in 2012 calls for a 5 percent increase year over year to $102.12. Given the more than 20 percent increase in gas prices year to date, odds are there will be at least some negative revisions in the coming weeks that will reduces the S&P 500 operating expectations.

While many will look at the 13.7 times earnings multiple for the S&P 500 and say it looks inexpensive, we have to remember that metric is multiples of the expected earnings growth rate. In 2011, the S&P 500's earnings grew 14.2 percent, which was essentially in line with market multiples. Rarely do we see valuation multiples expand when earnings are slowing.

Chris Versace is editor of the PowerTrend Brief and PowerTrend Profits newsletters. Visit them at ChrisVersace.com, or follow him on Twitter @_ChrisVersace. At the time of publication, Mr. Versace had no positions in companies mentioned; however, positions can change.