Dorsey: How Earnings Can Do Well in a Weak Economy

Pat Dorsey: Hi, I'm Pat Dorsey, director of equity research at Morningstar. With earnings season winding down, it's worth taking a look back and seeing what we now know. Earnings season is always a good time to check in on the bottom-up health of the economy.

You get these macro level data points every week, whether it's the labor report or inflation, or this or that, and the various pundits seize on these to make giant sweeping conclusions.

But at the end of the day, the stock market is driven by, shocker, earnings. And we now have a lot of data to look at and see what's been going on.

So, over the past few weeks, we've seen a not terribly surprising trend: basically the strongest revenue streams came from exports, companies that were selling to markets outside the U.S., companies exposed to a lot to business spending, technology in particular, in addition to firms like, say, Illinois Tool Works and Caterpillar also turned in pretty respectable numbers.

And of course, any company that was very closely tied into the consumer, especially discretionary spending, results were not so good. And this is pretty consistent with what we've seen and the thesis we've been advocating for a while now, which is consumer deleveraging--the consumer paying down their balance sheet, paying down their credit card balances, borrowing less money given that home prices are down, you can't use your house as an ATM anymore. That is going to act as a big drag on companies exposed to consumer spending.

However, not all U.S. companies are consumer-centric. You hear this stat that two-thirds of the U.S. economy is the consumer, and you get freaked out. You think, my gosh, the stock market can't go anywhere. Well, as we've seen over the past year or so and especially during this past earnings season, a lot of companies exposed to the consumer, say your local dry cleaner, your local deli, well, they are not public.

About 40% of S&P 500 earnings are tied to income sources outside the U.S., so not tied to the U.S. consumer or U.S. business. And then a pretty good size chunk of that remaining 60% is tied to U.S. business spending. So, as we've seen, earnings can do well even in the face of a fairly lackluster economy, which is certainly what we're seeing right now.

Just to highlight a few companies in particular, I always like to use Illinois Tool Works. The ticker is ITW. It's kind of a bellwether for a lot of what happens in the economy. Their products touch mainly business spending areas, but they touch some consumer areas as well, and they're pretty short cycle, unlike a company like, say, Boeing or Caterpillar, where buying a giant earthmover or an airplane is pretty long-term decision, what we call a long-cycle business.

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But ITW's products are going to be more short cycle. Things that you need now and you make more purchase and then you get them delivered and use them. And because of that it's a pretty good metric on how the economy is doing.

ITW's numbers are about 21% versus last year. Caterpillar also did well. 3M, which is a little bit more consumer exposed than ITW, also turned in very robust numbers. So, again, that trend that we're seeing with companies exposed to more business-centric areas really have turned in pretty good numbers over the past quarter.

Yum! Brands is worth mentioning because it also illustrates the theme I was mentioning with non-U.S. sales doing very well. Yum! Brands gets a lot of its revenue from China especially; their Kentucky Fried Chicken, the KFC brand, has just been going gangbusters in China for several years; much, much bigger than McDonald's over there. And of course that segment of the business turned in pretty good numbers as opposed to their domestic Taco Bell and Pizza Hut operations, which held up okay, but even though they are kind of value priced, didn't do nearly as well as their non-U.S. operations.

One sector I think that's worth highlighting in particular, a data point that came in during earnings season, is the banking sector. Now, a lot of banks turned in pretty good numbers relative to last year, and I think that credit quality has been improving at a pace that surprised even banking bulls. I don't think anyone was forecasting at the depths of the crisis that credit quality would improve as quickly as it has been. We were seeing charge-offs coming down. We are seeing banks with less provisioning--basically a bank provisions when it reserves money against future bad loans, and when those provisions come down, that means the banks are seeing that loan losses will moderate and loan quality will be going up in the near future. These are both very strong trends we saw, very positive ones for banks in the U.S.

However, the big fly in the banking ointment was revenues. Loan demand was quite weak for many banks with the exception of Wells Fargo, which has always been a standout on the revenue and cross-selling angle. But loan demand was just pretty weak across the board for most banks.

One data point that might highlight this, credit card balances for Bank of America's credit card book--and Bank of America is one of the top three or four credit card providers in the United States--credit card balances at Bank of America were down 15% versus last year. In the middle of a weak economy, you would expect people to be borrowing a little bit more, maybe using their credit cards more, because they're not getting the income. But people are paying down debt and are not using their credit cards as much. Some of that, of course, is tied to tightening loan standards.

But again that's part of this whole deleveraging theme we've been talking about for some time, and it highlights what I would call a low probability but high severity risk for banks, which is that, you'll be heading to a very deflationary environment and the steepest yield curve in the world with great interest spreads for banks and improving credit quality, less competition from shadow banks, all these great positives for banks could be overshadowed, if they can't make loans, because nobody really wants to borrow. And that's a huge risk that's worth watching for banks with revenue coming in as weak as it was.

So probably one of the biggest flies in the ointment, unexpected ones that we saw coming through in an earning season that was otherwise pretty positive and highlighted the general themes we've been talking about for some months with consumers weak but business spending and exports spending still coming in quite strong, which is allowing S&P earnings to do fairly well even in the phase of a pretty weak economy.

I'm Pat Dorsey, and thanks for watching.