By: David Sterman of Street Authority
Over the past few years, a predictable trend has dominated earnings season. Analysts lower their profit forecasts in the weeks and months ahead of quarterly results, and then companies manage to slightly exceed the lowered set of expectations. It's happening again.
According to FactSet Research, on an aggregate basis, analysts lowered Q3 profit forecast by 4.2%, slightly above the typical 2.7% downward revision of the prior 20 quarters. In theory, lowering the bar further should boost the chances that companies manage to exceed current consensus forecasts.
But the typical "cut and beat" game may not be the key theme this time around. As third quarter earnings season gets underway later this week (as Alcoa (NYSE: AA) weighs in on Wednesday, October 8), a range of cross-currents promise to make this one of the more unpredictable earnings seasons in quite some time. Both positive and negative factors are likely to keep analysts and investors on their toes. This is not time to take a casual approach to earnings season. After rising 6% in the first six months of 2013, the SP 500 rose less than 1% in the third quarter.
Here are four key themes you need to monitor to help get a sense if the SP 500 can resume its upward trajectory in the fourth quarter:
The Currency Headwind
The U.S. dollar has been rallying sharply since mid-August and now stands near 52-week highs against the euro, the yen, the pound, the Australian dollar and many emerging market currencies. Credit (or blame) goes to an expectation that U.S. economic growth will be relatively more rigorous in 2015, leading to widening interest rate gaps. Currencies anticipate interest rate changes. The strong dollar is bad news for many U.S. multi-nationals, who lose a competitive edge in global markets against foreign competition. At a minimum, profits earned abroad in foreign currencies will be diminished as they are repatriated back into dollars. As a result, Q3 results, along with forward guidance, are bound to be dampened by the currency swings.
If the dollar rallies further in coming months, as many foreign exchange strategists expect, companies may need to reconsider the wisdom of holding so much cash abroad. Firms don't want to take a hit to taxes as cash is brought back home, but those foreign currency holdings are starting to lose value on a weekly basis.
Good News/Bad News In The Oil Patch
The energy industry is suddenly in flux as crude oil prices move lower. The rising level of domestic production, of both oil and gas, means that many firms will "make it up on volume." But for the energy exploration firms that are focused on hard-to-access energy regions (such as offshore), industry dynamics are changing for the worse, as some energy fields become economically infeasible.
The Market Vectors Oil Services ETF (NYSE: OIH) slumped 18% in the past three months, anticipating a tough earnings season to come. Many may be tempted to bottom-fish, but it's wise to wait and see how earnings season plays out. A month from now, we'll have a clearer sense of how the view into 2015 is shaping up for the energy sector, and we'll also have a better sense of whether oil prices found a floor or are entering into a cyclical slump.
Pillars Of Strength
After expanding a robust 4.6% in the second quarter (partially aided by sequential comparisons to a subpar first quarter), economists think the U.S. economy grew a solid 3.0% in the third quarter and will do the same in the current quarter. What's driving the momentum? Corporations are boosting investment, as I noted a few weeks ago, while consumers may also become more emboldened to do their part.
The key for earnings season is the degree of domestic exposure that each company has. As Nike, Inc. (NYSE: NKE) noted on its September 25 quarterly conference call, "North America continues to be a growth driver for the company, with Q1 revenues up 12%." That news comes despite the ostensible boost that the World Cup should have delivered in Nike's foreign markets.
The domestic-foreign dichotomy is at odds with the recent market action. Large cap and mid-cap stocks typically have greater foreign exposure and their key indices are near all-time highs. Yet small caps have a greater degree of domestic exposure but have been trading poorly in recent weeks. The larger firms will be delivering their results and outlooks over the next two-to-three weeks, while small caps will mostly be weighing in over the subsequent two-to-three weeks. Perhaps the market action is telling us that all is not well in small cap land. Or perhaps investors' increasing focus on large and mid caps will prove to be misplaced.
Buybacks, Dividends And Margins
Companies are on a clear hiring spree, creating 200,000 net new jobs every month -- the most robust pace in more than a decade. Coupled with their investments in capital equipment (noted above), it's fair to wonder if profit margins will come off of their record highs. And if so, how will investors respond? Year-over-year margin declines are often seen as a clear negative if it indicates a lack of pricing power. But in this instance, sacrificing margins for future growth can surely be spun in a positive light.
The other issue related to higher spending on personnel and equipment is that less money is available for buyback programs and dividend boosts. Those two shareholder-friendly perks have surely been a factor in this bull market. If the shift away from dividends and buybacks becomes an incipient trend in the third quarter, then it could impact market psychology.
Risks to Consider: Europe has been troubled for quite a while and may be drifting towards recession. China, the engine that drives Asia, is also showing signs of cooling. No matter how the U.S. economy fares in the fourth quarter, foreign operations may blunt results at many firms.
Action to Take-- Mid-way through earnings season, on October 29, the Federal Reserve will provide a fresh statement about interest rate policy. The conventional wisdom holds that the Fed will deliver "more of the same," despite clear momentum in the job market (at least in terms of quantity if not quality). Indeed the Fed seems to be holding the reins to this bull market, rendering earnings season a bit less meaningful. Then again, a change in Fed interest rate language would shift the bull market's burden to quarterly corporate results. So keep one eye on the companies you are tracking, and one eye on the economy as you navigate the upcoming earnings season.
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