Stocks are at all-time highs, despite the jobs disappointment on
Friday and tepid GDP numbers on Wednesday.
Reasonable people can disagree over what forces drive the stock
market, but no one can deny the centrality of earnings to stocks.
Some even go to the extent of calling earnings the 'mother's milk'
of stock prices.
So, if stocks are doing this good, then earnings must be in very
good shape. But are they?
My answer is: No. The market is pricing a view of earnings that is
unlikely to play out. This, in my judgment, is the weakest link in
the current positive narrative driving the stock market rally,
particularly if the Fed is getting ready to get out of the QE
Earnings growth has been essentially non-existent over the last few
quarters, including Q2. But consensus estimates look for growth to
resume in the second half of the year and accelerate into 2014.
I don't think it's going to pan out like this and want to share the
basis for my skepticism in this write-up. I am by no means
suggesting an earnings train wreck or a call to exit the market
altogether. What I am suggesting instead is that current earnings
expectations are vulnerable to significant downward revisions. And
an acceleration in that negative revisions process will most likely
result in the market giving back some, if not all, of its recent
You don't have to agree with my conclusions. In fact, many of my
colleagues here at Zacks don't agree with my view. But it would
nevertheless pay to be a little skeptical of current earnings
expectations, take another look at your portfolio and perhaps
reposition it for an extended period of weakness.
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How Good is the Q2 Earnings Season?
By most conventional measures, the Q2 earnings season doesn't seem
to be that different from what we saw in Q1, and would generally be
considered 'good enough' or 'average'. But once we dig a bit
deeper, we find that a lot of the respectability for Q2 earnings is
due to one sector alone - Finance. From my vantage point, the Q2
earnings season has been 'below average'.
Total earnings for the 393 S&P 500 companies that have reported
Q2 results as of Friday, August 2nd are up +1.6%, and 66.7% have
beat earnings expectations. Total revenues are up +1.9%, with 53.2%
beating top-line expectations.
Look at the two side-by-side charts below that compare Q2 earnings
growth with Q1 and the 4-quarter average. The first chart compares
the results for all 393 S&P 500 companies that have reported
already with what these same companies reported in Q1 and in the
preceding four quarters. The second chart does the same thing, but
takes the Finance sector out of the data. You would be justified in
giving the Q2 earnings season an 'average' grade by just looking at
the left side chart. But I doubt you will maintain that grade after
seeing the right side chart.
Finance is no small fry, as the sector is on track to bring in
almost 21% of all S&P 500 earnings in Q2. But there is a big
world outside of Finance and it's hard to be satisfied with the Q2
earnings performance of this ex-Finance world.
Chart 1 - Q2 Earnings Growth for S&P 500 Compared - With
& Without Finance
Note: The data compares the growth rates for the 393 S&P
500 companies that have reported results, as of Friday August
Expectations for the Coming Quarters
Expectations for the second half of the year have started coming
down as companies are guiding lower on Q2 calls, with estimates for
Q3 coming down particularly strongly.
The chart below shows how estimates for Q3 have evolved over the
The downward adjustment to Q3 expectations notwithstanding,
estimates for the second half of the year still represent a
material acceleration from the first half's trend, particularly for
sectors other than Finance.
The chart below shows the quarterly earnings growth expectations
for the second half of the year and results for the current and
prior two quarters.
Chart 3 - Expected S&P 500 Earnings Growth Rates, With
& Without Finance
Note: The reason for the variance between the growth rate for
2013 Q2 in chart 3 vs. chart 1 is that chart 3 is presenting the
composite growth rate for Q2, meaning a blend of the 393 companies
that have reported already with the 107 still to come.
To provide a context for the above consensus growth expectations,
chart 4 shows the quarterly earnings totals instead of just the
Chart 4 - Total Quarterly Earnings, With & Without
What we see here is that total earnings are already at an all-time
record level, but they are expected to go even higher in the last
two quarters of the year.
In essence, consensus expectations are for a +7.6% growth in the
second half of 2013 after the much more modest +2.2% gain in the
first half. Excluding Finance, growth is expected to ramp up to
+5.5% in the second half of the year after the -1% decline in the
first half. This growth momentum is then expected to carry into
2014, giving us earnings growth of +11.1% for the S&P 500 as a
whole and +11.6% growth for all the sectors outside of Finance.
How Realistic Are These Expectations?
I don't think these expectations will pan out. And here is why.
Earnings can grow only through two ways - revenue growth and/or
margin expansion - and the outlook on both fronts is problematic.
Margins are already at cyclical peak levels and the best that can
be expected on that front is for margins to remain stable. That
leaves revenue gains as the major avenue for earnings growth. But
you can't have significant revenue gains in the current constrained
economic growth environment since revenue growth is a direct
function of (nominal) GDP growth.
It may be hard to believe after the tepid GDP and underwhelming
jobs reports, but the U.S. economy is actually in better shape
relative to its trading partners. But that's only in relative terms
- the reality is that the U.S. economy is at best on a sub-2%
growth trajectory. Bottom line, it's hard to envision companies,
particularly outside of Finance, overcoming their revenue growth
problems in the coming quarters in this economic growth backdrop.
So What Gives?
Not only are margins already at record levels, but corporate
earnings as a share of GDP are also at multi-decade highs. Just
like trees don't grow to the skies, margins and the ratio of
earnings to GDP don't expand forever either.
What all of this boils down to is that current earnings estimates
are high and they need to come down - and come down quite a bit.
One could reasonably draw a scenario where earnings growth turns
negative, though the more likely path appears to be for earnings
growth to flatten out.
How Do You Invest in this Environment?
The way to invest in such an environment is to look for stocks that
don't reflect aggressive growth expectations and enjoy
company-specific growth drivers not tied to broader macro trends.
Companies that generate plenty of cash flows beyond their immediate
capital needs and have track records of sharing excess cash with
shareholders through dividends and buybacks are particularly well
suited for a period of sub-par earnings growth. Bottom line, look
for thematic stocks with strong defensive attributes.
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