As we head toward the end of the first quarter of 2015, we are also closing in on what is affectionately called “earnings season.” Four times each year – after the end of each calendar quarter – public corporations report their financial results for the previous three months, then update their outlook for upcoming periods. The media hypes these reports with “breaking news” slogans and fancy graphics, as if watching election returns or the NFL draft. Although it might be a little over-the-top, there is good reason for all the hyperbole.
Earnings season is a time for investors to get meaningful insight about many important metrics driving the economy. Delivered in a way that shows revenue trends across many industries and sectors, it is a real opportunity to see how households and businesses are spending their disposable cash flow. Of course, earnings per share (EPS) is one of the most popular metrics for valuing stocks, but the number can be – and often is – manipulated by management to deliver a pre-determined level. As such, revenues give a cleaner view of activity. Many of the economic data we regularly follow is released with a lag and the reports provide no forward guidance, so it is, at best, a snapshot of where things were at a previous point in time – still important but not as current as the information we get during earnings season.
We’ve talked before about the strong economic headwinds prevailing outside the United States as well as the significant appreciation in the U.S. dollar over the past nine months. The impact of slower growth overseas, weak export demand and the strong dollar might be enough to shake U.S. equity markets in coming weeks, particularly if the results miss already-lowered earnings estimates. In a highly efficient market like U.S., large cap stocks’ share prices adjust quickly to revised estimates so some of the potential weakness may already be reflected today. Still, the actual results do matter and can have an additional impact if they are surprisingly different than expected.
The chart below accounts for all 500 stocks in the S&P 500 Index, broken out into 11 sectors. The EPS median based on consensus analyst estimates is shown for today compared with the median estimate from the beginning of the quarter. As you can see, no sector is expecting better results than they did at the beginning of the year. Some, like energy, are significantly weaker. The financial and utilities sectors are about flat but still slightly negative.
With the bull market now in its sixth year and valuation multiples at the upper end of historic levels, there is less margin for error when it comes to EPS achievement. While it is next to impossible to identify a top in markets, we do expect volatility in stocks to remain higher this year than last. In the short run this can be unsettling, but sell-offs that follow create opportunity for the long-term investor.
From a tactical point of view, we use the data points and comments provided by corporate management during earnings season as an opportunity to reaffirm our commitment to individual stocks, identify undervalued stocks that are beginning to benefit from positive momentum and, in certain situations, realize gains if the favorable trends or valuations are beginning to turn against us.
Overall, one quarter for any business does not define future success. However, earnings season is a good opportunity to get a nearly concurrent understanding of underlying economic activity across all sectors, which will ultimately impact the broader macro conditions including inflation, employment and monetary policy.
Jack E. Payne, CFA, CFP
Chief Investment Officer