Aim High, Buy Low

With the U.S stock market under even more scrutiny, Q2 earnings may be game changing. The fear is that estimates will once more be low-balled, thus concealing the true state of the US equity market.

It’s that time of year again when market focus concentrates on earnings amongst the largest companies in the U.S. The largest 500 are due to publish their financial results for the 2nd quarter of 2013 over the course of the next 4 weeks. We urge all market participants (even those solely focused on FX, commodities and metals) not to ignore this potentially key factor. The health of the U.S. equity market is currently a dividing issue because it directly relates to unemployment, personal income, inflation and US GDP – all of these are currently in the spotlight because of the Fed’s forward guidance i.e. its intent on gauging unemployment, inflation and GDP in deciding when to taper its asset purchases. Moreover, U.S earnings give investors an intuitive glance into broader demand & supply conditions not just in the U.S, but also globally.

In recent earnings seasons, analysts have been quick to point out that the highs seen in the S&P were largely unjustified, that earnings estimates have often been lowballed (making the actual results look better than they are) and that the Fed’s asset purchases have been artificially supporting equities since 2009 – with the conclusion that the bull run would be over once a set of poor quarterly results surfaced because the bullish S&P is not sustainably high, but rather speculatively high. However, they’ve been repeatedly proven wrong, and the stock markets have pushed higher, printing fresh highs even beyond those made prior to 2008.

So far, 21 companies have reported their Q2 results early due to their accounts period ending in May rather than June. 62% have beaten estimate consensus with aggregate yearly EPS growth of 7.9% and revenue growth of 5.8%. It seems that the lowballing equity bulls are at it again.

Full day by day schedule of Q2 earnings

Q2 earnings expectations have fallen drastically since April (conveniently setting the stage for day after day of headlines showing company outperforms and stock market gains). As of today, total earnings for companies in the S&P are expected to have grown by 0.4% since Q2 2012, compared to 3.9% in April.

The devil is in the detail

Finance is reclaiming its dominant earnings and market capitalisation position within the S&P. Technology remained the biggest earnings producer for the S&P from 2008-2012, but the leadership role will probably move back to Finance this year. Finance is the only major sector with a strong growth profile, with total earnings for the sector expected to be 18.6% higher in Q2. This follows +7.6% earnings growth in Q1 following many prior quarters of growth.

If we exclude Finance from the S&P, total earnings would be -3.2% in Q2. Looking deeper still, we can see that of the industries comprising the Finance sector - banks, brokers and insurers are all expected to show positive but the truly stellar outlook can be seen when looking at brokerage and investment management firms like Goldman Sachs and Morgan Stanley. This particular group of firms is expected to be up 38.7% in Q2 after a 2.6% gain in Q1. The banks and brokerage firms are the growth engines of the S&P and the U.S economy but they themselves are ridden with debt, relying on Fed support to post strong results! Putting aside the alarm bells this one fact should be inducing, its important to realise that markets can behave irrationally for much longer than you can stay solvent i.e. despite the fact that equities are probably incridibly overpriced, they can still appreciate. For FX traders, a strong US equity market tends to mean growing risk tolerance, more leverage and higher highs in most risk-sensitive asset classes.

Finance-led recovery

The earnings picture for the Technology sector remains fairly weak. Total earnings for the sector are expected to be -8.3% compared to Q2 2012, following the -4.2% earnings decline in Q1. Excluding Technology, total Q2 earnings for the S&P 500 would be +2.4% compared to Q2 2012. Expectations for Q2 earnings remain low, having come down significantly over the last few months. ‘Lowballed’ expectations provide an easy hurdle for firms and encourage investors to buy stocks, expecting prices to rise. Conversely, investors are quick to sell stocks if earnings estimates are missed. This indicates that market participants are excessively speculative. The whole point is that estimates vs. results is a game with many interpretations and it’s highly likely that with undesirable results looming, the same people that provide the earnings estimates (analysts at financial firms) are incentivised to make predictions that fall in line with a pre-set consensus. Low-balling is a game played by many but only a handful set the tune.

The further estimate expectations fall, the better the actual earnings result looks when it’s announced. This counterintuitive phenomenon has helped each earnings season to look better than the last, when the core truth is that most U.S companies are stagnant and are actually contracting. There is not much earnings growth outside of the Finance sector in the U.S. Most sectors of the U.S economy would show negative earnings growth if they were look at individually rather than pooled together. Finance is essentially pulling the US economy along.

The charts below show the share of total earnings for 2013 as well as the share of total market capitalization for various sectors in the U.S economy. Finance is on track to regain its prominent position in the index in terms of earnings contribution this year, though it still remains significantly below its record 27% share in 2007.

 

Outlook

The Q2 earnings season will feature prominently in the headlines over the next month. Particular attention will be on bellwether stocks such as Citigroup, IBM, Alcoa, Apple, GM, Pfizer and others because they represent a good overview of broader market trends (given their size and market share). We see earnings posing significant event risk for FX pairs because of the connections to GDP and monetary policy. Bear in mind, that a stellar earnings season would increase chances of Fed tapering while horrible earnings would reignite speculation that the Fed will continue with asset purchases for longer. The truth (as if often the case) is somewhere in the middle ground, so we’re likely to see a largely ‘as expected’ earnings results but with a positive skew so that equity markets maintain their bullish bias.

We have a limited macro data on the economic calendar this week, although Wednesday’s FOMC minutes will be intriguing because of the hyper focus on the Fed and its QE taper plans. See the Economic Calendar for details

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Commissioned by Think Forex

Written by George Tchetvertakov

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