MorningWord 8/19/13: This weekend the cover story of Barron’s Beware Falling Profit Estimates is definitely worth a read, no matter where you stand on the Sports Illustrated/ Barron’s cover curse. For the moment, investors are looking at Q2 earnings and Q3 guidance as a minor speed-bump in the latest leg of the bull run, and it really wasn’t until last week’s high profile misses from CSCO, M and WMT, that investors even seemed to take notice, but as the article suggests;
“opportunities for easy earnings gains through cost-cutting have shrunk. There’s evidence that more companies are falling back on a bad habit: using accounting adjustments to earnings to beat estimates.”
This point should have hit home this past week with CSCO investors as the company met their quarter just reported, but guided down for the current quarter, spoke to less then stellar visibility which ultimately will result in announced layoffs of 6% (4,000) of their workforce.
Which leads us back to the ol’ question about expectations from analysts and investors alike with the S&P 500 within 2% of the all time highs, at a time when the FOMC is in a fairly healthy debate about the future degree of quantitative easing. While Q2 is already baked in the cake, Barron’s cites:
The consensus estimate on Wall Street assumes that earnings growth will accelerate to 3.9% in the third quarter, and more than double, to 10.5%, in the fourth. The third-quarter estimate has already been slashed by more than a third since the end of June (Among 92 companies in the S&P 500 that have issued third-quarter guidance, 82% have guided lower, versus a five-year average of 62%), but the fourth-quarter forecast has barely budged from 11.9%.
So the second half earnings recovery that is largely the reason given for the 16% rise ytd in the SPX anf the 19% rise in the Nasdaq may prove to be a bit more elusive than originally thought, and may remain challenged as we head into 2014 as we get what is feeling like and annual occurrence of Congress haggling over the debt ceiling. Barron’s cites what could be overly optimistic forward estimates leading to what could be stock valuations that currently look reasonable, having the potential to look downright expensive if revisions continue at current pace:
For the first two quarters of next year, published forecasts show continued strong earnings growth of 6.8% and 11.1%. Replace those numbers with more realistic assumptions, and the stock market appears pricier. Assume, for example, that earnings growth will indeed quicken but will average 5% over the next four quarters. That would push the valuation of the S&P 500 to 15.3 times forward earnings, just about where it was when the market peaked in October 2007.
Another important point that could be demonstrating slowing earnings momentum, which we have cited on more than a few occasions of late, is that the “beat rate” has been dwindling and the concentration of earnings growth in one sector (financials) shows a fairly bleak earnings breadth:
most companies beat earnings forecasts in the second quarter, but the average size of the beat, 2.4%, was less than the four-year average of 7%, according to FactSet. Financials drove all of the earnings growth and then some during the quarter; ignore them and earnings were down about 3% from a year ago.
Again, Q2 is backward looking, but the warnings from numerous retailers of late, and what appears to be fairly poor visibility into the all important “back to school” selling season could set up for some positive surprises given what is now turning into slightly lower expectations, at least from a sentiment standpoint.
As we head into the Fed’s Sept 17-18th meeting the markets, at least in the U.S., will continue to be on edge as interests rate will likely be the “tell” on the Fed’s Taper plans. We will also be heading into the last 2 weeks of Q3, where companies will be aggressively trying to close deals to meet their quarters, and where analysts will be getting their ducks in a row as it relates to their earnings estimates for Q3 and the balance of the year. Like the Fed, many analysts may be “data dependent” so to speak for the coming quarters if the Fed was in fact to signal that they would buy less bonds in the near future as opposed to sometime in early 2014. After what has appeared to be a veritable period of calm for U.S. markets since the opening print of the year back in January, things may get a bit more interesting for the balance! You didn’t just think you were gonna be able to walk off into the sunset with 15-20% gains in 2013 without any real test of your investment faith did you??