Hopefully, this week will be marked by a return to fundamentals in the stock markets. Instead of concentrating on vague feelings that we are trading higher than we should be, whatever that means, or worries about China growing at “only” 5 or 6 percent this year, or seeing political and economic problems in Brazil as a reason to sell stock in companies who do business only in the U.S., maybe, just maybe, we can start to focus on the actual performance of companies and the conditions in the world’s largest, most influential economy.
Don’t get me wrong, I have nothing against volatility; I was trained in a dealing room and have made a living from movement in markets most of my life. It is just that what we have seen over the last couple of weeks has been based on emotion, not logic. That makes it hard to trade successfully and almost impossible to invest for the longer term with any confidence. As we get into earnings season, however, we can start to look at whether the things that we have been worrying about are actually impacting what really counts: corporate profits.
The thing is, the worries that have caused the volatility are, while forward-looking by nature, really nothing new. Talk of slower growth in China was underway by the beginning of this year, and at that time oil and other commodities were already well into their epic collapse. Oil, for example was actually trading a couple of bucks lower than present levels for most of January. What we should begin to see in this earnings season is to what extent those factors have actually had an impact.
The first clue with regards to China will come when Yum! Brands (YUM) report on Tuesday. The majority of their earnings come from that market with significant contributions from other emerging markets such as India. YUM is forecast to show earnings growth, from $0.87 a year ago to $1.08 this time around, but don’t get too carried away assuming that growth in the company’s Chinese earnings equates to overall Chinese strength. Yum! is still recovering from a food scare that hit earnings hard, so improvement is natural. The consensus expectation of $1.08, however, takes that into account, so it will be performance relative to that, and to revenue expectations, that count.
Part of the reason for weakness in emerging markets, of course, is overall weakness in the commodity markets on which so many smaller countries depend. Thursday will give us an insight into the state of those markets when Alcoa (AA) reports. At this time last year, commodity prices were just about at their peaks, so a large decline in EPS, from $0.31 to $0.16, is expected by analysts. With such a gloomy outlook it is logical that there is more potential for a positive reaction than for the opposite. It won’t take much - just meeting expectations and suggesting in the subsequent call that the sky isn’t actually falling will probably be enough to lend support.
In fact, that contention, that a gloomy outlook makes any news likely to seem positive by comparison, can be extended to the market as a whole. Estimates have been revised downwards as pessimism has increased, so it won’t take much to result in some pretty impressive beats. This is nothing new. As I pointed out about a year ago, it has been the case ever since the recession that analysts have underestimated earnings. That is probably even now a “once bitten, twice shy” kind of thing; nobody wants to be the one still shouting “buy, buy!” when the next crash comes, so paying attention to any fears about the future makes sense.
That article last year, however, also pointed out that this particular tendency often lends support to the market as it has led to a situation where two thirds of companies beat expectations every quarter. That would be particularly welcome this time around, as it may allay fears somewhat and return the focus to something pretty basic. We may have worries about the future, we always do, but it still looks as if the U.S. economy is grinding on with a slow but steady recovery, and U.S. stocks, therefore, are still a good investment.