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Don’t Be Fooled by Noise, Earnings Will Tell the Truth


  • A look into next month’s earnings season and trends.
  • 6 out of 10 S&P sectors have earnings declining.
  • 72% of companies issued negative guidance.

Introduction

With all eyes focused on Brexit and the FED, it seems that no one really cares what is going on in the economy and, most importantly, with corporate earnings. Don’t forget that next month is earnings season and the earnings trend up until now has been a negative one. As corporate earnings are the main factor in stock returns, you should be focusing on how to prepare for that and not on Brexit as it will probably be forgotten by next week.

Many believe that predicting corporate earnings is not possible, but thanks to the multitude of data constantly published, it does not seem impossible. It just takes a lot of work and analysis.

This article is going to analyze sector-by-sector news in order to estimate the upcoming earnings season results.

Corporate Earnings

The main thesis behind bearish market views is that corporate earnings have been steadily declining for the past two years.

figure 1 Sand P earnings
Figure 1: S&P 500 earnings. Source: Spindles.

The little uptick in Q1 2016 was mainly due to commodities prices rising and smaller losses in the energy sector, but is still below Q1 2015 which marks five consecutive quarters of year-over-year declines in earnings. The main influence in the above decline comes, of course, from energy and materials, but don’t be fooled by that as 6 out of 10 S&P 500 sectors had earnings declining for an average decline of 6.7%.

figure 2 earnings by sector
Figure 2: S&P 500 earnings growth by sector. Source: Factset.

Energy

Energy earnings are easy to predict as they are related to crude oil and gas prices. Stocks usually follow those prices, so it is difficult to get a significant prediction here.

figure 3 energy earnings
Figure 3: S&P 500 energy earnings. Source: Spindles.

As crude oil and gas prices have been on average much higher than in Q1 2016, we should not expect negative surprises in the sector, but earnings will be again lower than Q2 2015.

figure 4 crude oil
Figure 4: Crude oil in last 12 months. Source: Bloomberg.

Materials

The story with materials is similar to the one for energy as prices have rebounded a bit but are still far below Q2 2015. The metal price index shows how the subdued commodity prices are not rebounding that fast and it will take a longer time for the lower margins to eliminate higher cost production.

figure 8 metal prices
Figure 5: Metal price index. Source: index mundi.

This slump in commodity prices is going to keep material earnings depressed and far below the averages of the last 5 years but as the below figure shows, the industry is cyclical both in the long and short term, so traders could grasp the opportunities given by the high volatility and long term investors can buy the excellent low cost commodity producers at low historical prices.

figure 5 materials
Figure 6: S&P 500 materials earnings. Source: Spindles.

Consumer Discretionary, Information Technology and Healthcare

Consumer discretionary, information technology and healthcare were the bright lights of Q1 2016 with earnings growth but this is about to change as the majority of companies issued negative guidance.

figure 6 guidance
Figure 7: Number of S&P companies with positive and negative guidance by sector. Source: Factset.

Of the 113 S&P 500 companies giving guidance, 81 have issued negative guidance while only 32 have issued positive EPS guidance.

A good example of how earnings can be predicted is by looking at car sales. Automotive companies have low PE ratios as everyone expects a decline in sales but the decline is not coming. Car sales have fallen by 7.4% year-over-year but this has been covered by increases in minivan sales.

figure 7 car
Figure 8: U.S. car sales. Source: Wall Street Journal.

For those interested in particular automotive companies and monthly sales, a site to watch is Motor Intelligence. For example, General Motors witnessed a 5% yearly decline in sales which is going to have a very negative effect on earnings while Ford managed to increase sales by 4% in the U.S. for the same period.

Longer Term Earnings Expectations

Analysts are always positive as they are mostly employed by investment banks and whose goal is to pump asset prices in order to gain more on commissions. Therefore, analysts will always see declines as just temporary and base their estimations on the rosiest scenarios. The current trend sees declining corporate margins but analysts expect this trend to turn around immediately.

A good way of debunking this assumption is to compare the current analysts’ estimations with the same from a year ago.

figure 9 analysts estimates margins
Figure 9: Current analysts’ S&P 500 corporate margins estimations. Source: Factset.

Analysts’ estimates from the same period last year were much rosier than what really happened and it is difficult to expect margins improving with full employment negative guidances.

figure 10 estimates last year
Figure 10: Analysts’ S&P 500 corporate earnings estimations from last year. Source: Factset.

The current profit margin is 9.7% while last year analysts estimated a profit margin of 10.6% for this period.

Conclusion

Corporate earnings can be partly estimated for subsequent quarters as lots of data—like car sales or retail trends—are publicly available on a monthly basis. By tracking such indicators an investor can minimize the risks of being caught up in a stock amidst a negative earnings surprise. As in the longer term there are many factors that can lower or increase earnings like the strength of the dollar, Chinese demand or oil prices, no one can know what will happen but can assess the probabilities of something happening and the effect on a portfolio.

The current trend is a negative one showing no strong improvement signs as commodity prices are still subdued. The economy is reaching full employment which should increase operating costs, and buybacks are not that profitable for companies as they are paying high prices for their own shares.

 

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