Earnings drive the stock markets, and the news on this front is sobering. Earnings growth in Canada is losing momentum and, in many sections of that market, earnings have dropped from recent highs.

In materials, one of the largest sectors, earnings have dropped despite rising industrial metals prices — their major component.

In energy, now the largest profit producer in the Canadian market, earnings growth has been inconsistent, so the small drop in June is probably insignificant in terms of trend.

The financials sector is the second-largest profit producer and, within it, diversified financials have dropping earnings. Rate of change in bank earnings growth has dropped uncomfortably close to zero again.

This has obvious implications for the Canadian stock market’s direction. And the market’s abrupt price drop in May and June may have been in anticipation of further drops in earnings.

These trends show up in industry components of the S&P/TSX composite index. Among the 23 industry groups into which the index is divided, eight continue to show a rising earnings trend. Three of the 23 groups — biotechnology, technology hardware and semiconductors — have no earnings to report. (Note that four “sectors” are also industry groups: energy, materials, telecommunications services and utilities.)

Of the eight groups with still rising earnings, energy, banks, insurance, real estate and transportation rank as largest. Consumer durables and apparel, food and staples retailing, and food/beverages/tobacco are small in comparison.

Overall, thanks to the heavy weighting of energy stocks in particular, earnings on the S&P/TSX composite continued to rise until May. But in June, composite index earnings dropped more than 3%.

(These comparisons are made with the TSX Group Inc.’s figures for the latest 12-month earnings. The 12-month totals smooth seasonal factors and other transient influences that can affect a quarterly profit figure. Each comparison made, for any period, includes a full four quarters of earnings.)

In the 12 months ended June 30, earnings for companies in the composite index totalled $71.5 billion, vs $73.3 billion for the year ended May 31, and $58.9 billion as of Dec. 31.

Adjusted to the index, those June earnings work out to $642, so the index traded at 18 times earnings as of June 30. This was slightly less than the market’s average price/earnings ratio throughout 2004, 2005 and for the year-to-date in 2006.

As of June 30, the TSX energy sector’s earnings had reached $26.9 billion, an 87% gain since mid-2003. Despite the 1% drop in June, it is ranked among the groups with still rising earnings. To put that in context, earnings of other industries have dropped as much as 69% over periods ranging from a few months to a year.

Banking, the largest portion of the financials sector, generated earnings of $14.2 billion in the 12 months ended June 30. Over three years, this has presented a remarkable gain of 92%. But on a year-over-year basis, bank earnings have been gaining only 1%-2% lately. In late 2005, bank earnings were lower. As a result, bank performances emphasize the slackening of earnings growth.

Even a larger dividend payout, now 51% of bank earnings, has been unable to prevent a 9% drop in the bank stock subindex from March through the end of June. The payout ratio was 45% a year ago and 42% two years ago.

A three-year comparison of an earnings gain for the materials sector is not possible because companies in that sector collectively ran at a loss in 2003. Earnings peaked last September, dropped to a low in February and have now regained part of the loss. Between September and the end of June, materials earnings dropped 8% to $8.6 billion.

Within the financial sector, insurance industry earnings have gained 33% in the three years ended June 30 and reached a high of $7.2 billion. Real estate industry earnings gained 61% in the same period, reaching $2.1 billion. But earnings of the diversified financials group have dropped 37% since the end of February to $900 million. Despite this drop, diversified financials’ profits gained 97% in the three years ended June 30.

Transportation is one of the largest and fastest-growing profit-making sections of the market. Earnings of this industry group in June reached $3 billion, up 424% in three years and more than double the total the year prior.

@page_break@Two smaller industries continue to generate earnings: food and staples retailing ($1.5 billion in earnings, up 23% in three years) and food/beverage/tobacco ($600 million, up 80%).

However, earnings have dropped recently in other sections of the market. For example, telecommunications services earnings have dropped 12% since last fall, consumer services earnings are down 29% since February, auto parts and components are down 15% since April, and commercial services and supplies earnings have dropped 69% since April 2005.

Momentum of earnings growth in this four-year bull run, as indicated by a 12-month change in the S&P/TSX composite’s earnings, reached a peak in November 2003. At that point, index earnings had increased 257%. That rate of gain slackened to 11% year-over-year last November but rallied to 22% at the end of May, a month in which energy sector earnings jumped 30%.

Rising dividend payments and payout ratios have been significant in bolstering stock prices. In the year ended May 31, dividends in the index gained 48%. As of June 30, the composite index indicated dividend payments for the coming 12 months were $31.9 billion, or 42% of earnings. A year prior, the payout ratio was 32%. And the yield on the composite index has risen to 2.5% from 2% on Dec. 31.
IE