Why This Earnings Season Is Especially Important

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Under normal circumstances, earnings season is eagerly anticipated by traders and investors, and for good reason. The estimates from analysts, and the estimates from CEOs on which they are based, tend to be made on the premise that it is better to underpromise and overdeliver than the other way around. That is why if you look back at past results, over two thirds of companies typically beat estimates. Understandably that usually gives the market a boost. This quarter, however, as earnings season gets underway, the market’s focus is elsewhere. Trade wars, Syria and political upheaval are preoccupying traders. However, in light of the resulting volatility and the precarious position of indices, this could be the most important earnings season in nearly a decade.

As you can see from the above chart, the S&P 500 is, along with the other major market indices, bouncing around levels that represent a ten percent drop from February’s high. As I wrote yesterday, that is significant as a ten percent decline is the accepted definition of a market correction. I also said that that level normally provides support. That is true, but as with all support levels, a sustained break below turns it into a point of resistance and encourages further selling. A below par earnings season would trigger such a reaction.

In large part, the run up to the highs earlier this year was because earnings estimates were being revised upwards across the board. Growth, both in the U.S. and globally, was accelerating and the full benefits of a low-tax, low-regulation environment for corporate America were yet to be felt. Even the energy sector, which has been a drag on the overall results, looks set to offer decent results as oil prices have stayed mostly above $60. Wall Street analysts have responded accordingly by raising their estimates for earnings.

Despite all of that, however, the market has fallen dramatically, as traders and investors focus on future risks, rather than past performance and current economic fundamentals. That combination of falling stocks and rising estimates is unusual, and drags the average forward P/E of the market, a common measure of valuation, sharply lower. As James Mackintosh of The Wall Street Journal points out in his Next Uparticle this morning, the last two times forward P/E have declined this quickly were during the Greek debt crisis in 2010 and in the aftermath of Lehman Brothers’ bankruptcy in 2008. As you may be aware, the market reacted very differently in the aftermath of those two events.

In 2008 it became clear that the problems at Lehman Brothers were not an isolated event and earnings fell rapidly across the board, bringing about the biggest drop in equity prices since the 1930s. The Greek debt crisis, on the other hand, turned out to be more along the lines of headline risk. U.S. corporate earnings continued to improve post-recession and the market recovered rapidly. What we will find out over the next few weeks as earnings reports come thick and fast is which of those scenarios is closest to the current situation.

Looked at logically, what we are seeing now is more akin to the latter than the former. The current volatility is, so far, largely based on fear, not fundamentals. The worry about the Fed raising interest rates faster than anticipated is admittedly more substantial, but they have said many times that they will only do so if the fundamental data continues to indicate that it can be done without major disruption. If Q1 2018 earnings indicate that those fundamentals remain strong and we get the usual percentage of beats of the new, much higher estimates, then stocks will rebound and continue on to new highs. But, if earnings are weaker relative to estimates than we have come to expect, the last month or so will be only a prelude to a much bigger drop.

It is easy to believe that as the headlines come thick and fast, they are what we should be reacting to. That is not the case. The next market moves will be decided not by Presidential tweets, FBI raids or heated rhetoric, but by the most fundamental factors influencing stock prices, actual profits and companies’ view of their prospects. Over the next few weeks we will find out more about these things. The message to investors is clear: don’t get distracted by the headlines, focus on earnings.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing , Earnings , Investing Ideas , Stocks , US Markets

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Martin Tillier

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