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As earnings season kicks into high gear in the coming weeks, many analysts expect an abundance of good news, mostly because earnings last year were abnormally low. And that bodes well for investors.
For the first time since the second quarter of 2007, earnings of stocks in the Standard & Poor's 500 Index should be higher than they were the year before. That would break the longest losing streak since S&P began keeping track of operating earnings in 1991.
"It's going to be on the plus side again," James Swanson, chief investment strategist at MFS Investment Management told The Wall Street Journal.
In fact, operating earnings for a group of companies selected by Thomson Reuters are expected to nearly triple on a year-to-year basis, mostly because of unfavorable conditions in 2008, when financial companies lost $81 billion in the fourth quarter.
American International Group Inc. (NYSE: AIG) reported a $61.66 billion loss, the largest in history.
The big question is whether the markets will continue to value bottom line profits as a catalyst to drive stocks higher – as they have in the last three quarters – or whether investors will start demanding revenue gains before rewarding stocks with higher prices.
Since last spring, the U.S. stock market has posted gains during each earnings season as companies posted results that were far better than expected – mainly because cost cutting boosted profits even as revenues declined.
Money Morning Contributing Editor Martin Huthinson expects earnings season to be generally positive for stocks, although he expects small businesses could disappoint because tight credit and reduced consumer spending has hit them particularly hard.
Even if S&P 500 earnings don't meet all expectations, he expects further stock market gains.
"Stock market investors these days have been able to rationalize bad news into good, so even slightly disappointing earnings most likely won't have much impact," he said in an interview.
Investors Should Look for "Beat Rates"
One of the concerns among investors heading into this earnings season is that the market is entering the reporting period in overbought territory. The S&P 500 is up 5.32% since the end of the third-quarter earnings season, the best off-season earnings since right after the second quarter of 2007, when the index rose 9.72%.
So how can you tell whether the market will trend up or down as earnings are reported?
The two numbers that impact the market dramatically are the earnings beat rate and company guidance, according to Bespoke Investment Group.
For earnings, the percentage of companies that beat expectations versus the prior quarter is what counts the most. The market has seen three straight quarters with an increasing beat rate from the prior quarter. And it's likely stock prices will react strongly to how the numbers come in the fourth quarter because analysts' estimates have stabilized from last year.
Failure to maintain an earnings-beat rate of 68%, which is comparable to the last two quarters, is likely to disappoint investors. Anything below 65% will likely be treated as a negative, Bespoke says.
As far as guidance from the companies themselves, for the first time in over a year, more companies raised guidance than lowered guidance in the third quarter, signifying a positive outlook.
Overall, 10.1% of companies raised guidance in the third quarter, while only 5.7% lowered guidance, an extremely bullish number.
That trend will need to continue for stocks to move higher. If the ratio of companies raising guidance versus companies lowering guidance is near 1-to-1, it would be a bad sign for stocks.
Volatility Likely to Increase as Companies Check-In
Whether companies beat their numbers or not, investors can expect increased volatility as earnings season gets underway in earnest. And that's especially true when bellwether stocks, that can turn the market on a dime, report results.
For example, when Alcoa (NYSE: AA) on Tuesday, said it earned 1 cent a share, after analysts expected it to earn 5 cents per share, trading volumes spiked and the stock got hammered. It traded as low as $15.48 a share after closing Monday at $17.45.
"They are still trying to rein in costs," Brian Hicks, portfolio manager at U.S. Global Investors' Resources Fund (Nasdaq: GROW), said of Alcoa, which cut 21,500 jobs and reduced capital spending by 52% to $1.6 billion since 2008.
But Alcoa's report has not historically been a leading indicator for the earnings season as a whole, and the company typically struggles on its reporting days, Bespoke noted.
Still, if last week's report from United Parcel Service Inc. (NYSE: UPS) is any indication, markets may still favor bottom-line profits over revenue.
When UPS last Friday said it would have to cut about 1,800 jobs, but raised its guidance, the stock barely budged. This week, the stock is up almost $5 per share, or more than 8% since last Friday's close.
News & Related Story Links:
- Wall Street Journal:
Earnings Rebound Expected in Fourth Quarter
- Wall Street Journal:
S&P 500's Composite 4th-Quarter Earnings Seen Nearly Tripling
- Standard & Poors:
- Bespoke Investment Group:
Earnings Season Analysis
Alcoa posts smaller loss thanks to better prices, lower costs