Friday, July 30, 2010

Q2 Earnings Season

Last Update: 12-Jul-10 09:19 ET

The moment the market has been waiting for is now upon us. After the close of trading on Monday, July 12, Dow component Alcoa (AA) will report its earnings results for the second quarter. That report will officially mark the start of the reporting period for the June quarter.
There has been a good deal of angst leading up to this reporting period. The performance of the S&P 500 has suggested as much.

From its intraday peak of 1219.80 on April 26 to its intraday low of 1010.91 on July 1, the S&P 500 dropped 17%. That decline was precipitated by sovereign debt problems in Europe, signs of a slowdown in China, a historic oil spill in the Gulf of Mexico, increased regulatory efforts, and a string of economic data in the U.S. that cast doubt on the sustainability of the economic recovery.
To be sure, there is a lot going on in the world around us that is creating a sense of uncertainty.  At the end of the day, though, it all comes back to earnings; and what has transpired in recent weeks has left the market questioning the achievability of earnings growth estimates. 

Those questions do not relate so much to second quarter earnings. Rather, they pertain more to earnings in the back half of the year and 2011.

While there is a realistic prospect of a relief rally during earnings season, we would be sellers into the strength, reducing exposure to cyclical sectors. Conversely, we recommend increasing allocation toward counter-cyclical sectors where volatility is lower and dividend yields are generally higher.

A Brief Look at Q2 Reporting

The second quarter results should go the way the results have gone the last two quarters. That is, the vast majority of companies reporting results should exceed consensus earnings estimates. The main factor behind that assumption is that there have been few warnings.

According to Thomson Reuters, there have been 71 negative EPS preannouncements for the second quarter compared to 60 positive EPS preannouncements. The negative-to-positive ratio computes to 1.2 for the S&P 500, which is less than the 1.3 ratio for the first quarter, when 78% of S&P 500 companies topped estimates, and well below the long-term average of 2.1.

In thinking of the second quarter specifically then, there are three questions left to be answered:
  1. How large will the earnings surprise factor be in aggregate?
  2. What type of top-line growth will we see? and
  3. What will the quality of earnings be?
The latest report from Thomson Reuters indicates share-weighted earnings for the S&P 500 are estimated to be $182.6 bln for the second quarter, which translates to an estimated growth rate of 27%.

Second quarter revenues are estimated to increase 9% to $2202 bln.

From April Fool's Day to Judgment Day

Over the last five quarters, S&P 500 companies have easily topped consensus earnings estimates. In the process, they have demonstrated the extent of their cost-cutting capabilities and have shown that analysts have been well behind the curve in accounting for the economic recovery from the depths of late 2008, early 2009.

In the first quarter, S&P 500 companies in aggregate topped the consensus earnings estimate by 14.3%. It would surprise us to see similar outperformance for the second quarter, especially since analysts have continued to bump up their growth estimates in the face of the market impediments noted above.
On April 1 the estimated second quarter earnings growth rate stood at 22.7%.

A lot has happened since April Fool's Day to get in the way of accelerating growth. That, however, has not stopped analysts from raising their estimates.

The third quarter earnings growth rate increased from 23.4% on April 1 to 25.6% on July 1, according to Thomson Reuters, while the fourth quarter growth rate increased from 31.5% to 32.6%.

There is little doubt given the scope of earnings surprises in recent quarters that analysts have been playing catch up with their estimates, yet we are left to wonder if they have finally caught up only to be left behind again with economic conditions softening.

A much smaller earnings surprise factor for the second quarter would speak to this concern.
The stock market, though, has not been content to wait on the second quarter results. Since the end of April, it has traded on the belief that analysts are too disconnected to what is going on in the world around them. That statement rings true in the charts below, which show the trend in the forward four quarter consensus earnings estimate and the S&P 500.

The correlation between the trend in estimates and the price trend in the S&P 500 weakened substantially in mid-May. The disparate moves make it apparent that one body is going to be proven wrong during the second quarter reporting period.

Either the stock market is too pessimistic or analysts are too optimistic. Accordingly, much is riding on the guidance from S&P 500 companies.

Lonely Analysts

There are a few markers in particular that must have analysts feeling like castaways on a deserted island.

The first marker is the Treasury market, which clearly thinks analysts are missing the boat on the economic outlook. On April 5, the yield on the 10-year note was bumping up against 4.00%. On July 6 it hit 2.93%. While the 10-year yield has recently moved back above 3.00%, the rush to own 10-year paper sporting a curiously low, real yield shows the level of concern about economic growth prospects.

Conversely, no one seems to be in a hurry to buy stocks despite a forward four quarter earnings yield that hit 8.6% on July 2. Granted there was a nice rebound in the S&P 500 in the past week, yet the 5.4% spike had a lot to do with short-covering activity if the extreme bearish sentiment readings, yet moderate volume totals throughout the week were any indication.

The significant equity risk premium is either a gift from the value gods or a bedeviling indication that earnings growth estimates are going to need to be marked down considerably. The reluctance to buy stocks at this juncture is supportive of the latter view.

On a related note, it was interesting to see that some of the worst sector performances in the second quarter were in those sectors that are expected to deliver the strongest earnings growth in the second quarter, as well as in the third and/or fourth quarters.

For example, earnings for the S&P 500 Materials sector are projected to increase 91% for the second quarter -- the highest of all sectors -- 46% for the third quarter and 45% for the fourth quarter, according to Thomson Reuters.

In the second quarter, the S&P 500 Materials sector declined 15.7% -- the worst performance of all sectors -- versus an 11.9% decline for the S&P 500.

Obviously, there is a big expectations gap that needs filling there, as well as in other S&P 500 sectors like Financials, Energy, Industrials, and Technology -- all of which are expected to deliver some of the strongest earnings growth in the second quarter and all of which underperformed the S&P 500 in the second quarter.

The List of Uncertainties Grows

There is a pervasive sense that the stock market has priced in what is expected to be disappointing guidance. That sets the stage presumably for a relief rally should S&P 500 companies come through on the guidance front.

Simply holding the line on prior guidance, or providing initial guidance that matches the consensus estimate, would qualify as coming through in this instance. Raising prior guidance, or providing initial guidance above the current consensus estimate, would be even better (to state the obvious).

A caveat for any relief rally is in order.

The short-covering spike in the past week was driven in part by not wanting to get whipsawed by any relief rally that might arise during the reporting period. Therefore, it is possible that some stocks will not go up as much as one might think if they deliver on the guidance front.

Nonetheless, barring an exogenous shock, the prevailing trend should be one of higher stock prices in the near term for companies that live up to reporting and guidance expectations.

What happens in the near term, though, is unlikely to change our view that tougher return conditions lie ahead.
The specter of higher taxes sits on the horizon; the EU and China are both implementing measures that should slow the pace of their economic growth; and the labor market in the U.S. remains a very troubled place.

Separately, politics risks adding uncertainty to the economic outlook.

Although the Treasury Department patted China on the back for not being a currency manipulator, there is still a strong current of rancor in Congress regarding that stance, which raises the potential for passing protectionist legislation, or at least jawboning about it, ahead of the mid-term elections.

On a related note, it seems likely that Republicans will stonewall on economic matters in the coming months in a bid to paint Democrats in a negative light for the electorate and to undo their majority control in Congress.

If successful, we could be looking at gridlock in Washington in 2011. That is apt to be looked upon favorably by the market if it were to occur. In the meantime, though, the road to gridlock could be a bumpy one if it entails keeping a new jobs stimulus bill from passing.

The Department of Labor has indicated that 3.3 mln people will lose extended jobless benefits at the end of July if a new stimulus bill is not passed.

Unemployment insurance payouts totaled $141.1 bln in Q1 2010, with $75.2 bln coming from extended benefits. The rise in extended jobless benefits contributed just under 0.2 percentage points to income growth. While this may seem small, total income increased only 1.0% during the quarter.

If extended benefits decline by 3.3 mln by the end of July, all of the income gains would be lost in the second and third quarter. This could be a significant hindrance to consumption growth over the next few months.
This is just one more uncertainty to consider.

--Patrick J. O'Hare,
Patrick J. O'Hare is the Chief Market Analyst for Briefing Research,'s new strategic research service. To request a free trial of Briefing Research, please email

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