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It's a proven fact — stock prices eventually follow earnings.
So as we enter second-quarter earnings season, an avalanche of corporate reports will likely set the tone for the stock market for the next six weeks.
If companies report healthy profits, stock prices are destined to charge higher. If earnings are flat or even begin show losses — look out below. U.S. stocks could tumble.
Either way, investors can expect increased volatility as earnings season kicked into high gear today with JPMorgan Chase (NYSE: JPM).
That's especially true when certain bellwether stocks report results. A bellwether stock, is loosely defined as company that tends to create, influence or set trends.
With that in mind, let's take a look at how earnings season is shaping up along with three stocks that will provide early clues about what might be coming for the rest of the market.
Predicting a Down Quarter for U.S. Stocks
Typically, earnings season is good for stocks.
Historically, the S&P 500 has rallied 67% of the time during earnings season, posting positive returns of roughly 3%. By comparison, stocks have dropped by 1.46% in between earnings seasons.
But we may not have much reason to cheer this time around.
Wall Street analysts project a 1% decline in second-quarter 2012 S&P 500 operating earnings, according to Capital IQ consensus earnings expectations.
The last time companies were this negative coming into an earnings season was the fourth quarter of 2008, when the financial crisis was wreaking havoc on the U.S economy.
Economic growth is slowing and hobbling economies around the planet, including the U.S., Europe and China. The Eurozone debt crisis just won't go away either, stifling credit flows.
And the U.S. dollar has been climbing against the euro and other currencies — crimping profits from international sales for U.S. companies.
As a result, companies have reacted by issuing downbeat quarterly forecasts. In fact, firms issuing negative guidance have outnumbered those with positive preannouncements by more than three to one, according to Thomson Reuters.
Ironically, the overwhelming bearishness could set the stage for a major rally.
Wall Street analysts have essentially set the bar so low that many companies could post upside earnings surprises.
Investors Should Follow "Beat Rates" & Earnings Guidance
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.
The earnings beat rate is simply the percentage of companies beating earnings projections. Guidance is information or an estimate that the company provides about future earnings.
"Earnings and guidance, if they are really good or really bad, will win out," Peter Tuz, portfolio manager at Chase Investment Council told thestreet.com.
That's because they give a broad snapshot of the financial health of the companies in the S&P 500 and whether the Index is likely to head higher – or lower.
For earnings, the percentage of companies that beat expectations versus the prior quarter is what counts the most.
A reading above 65% is particularly bullish. Anything below 50% is likely to disappoint traders and would be bearish.
Surprisingly, guidance from the companies themselves is often seen as more important than the actual earnings.
"A company can have an excellent quarter but then express caution with guidance, and the guidance will be listened to more than the actual number," said Tuz.
If more companies raise rather than lower guidance it would be a good sign for stocks.
Tuz expects the guidance will be exceptionally cautious because "you have just so much uncertainty out there."
Three U.S. Stocks to Watch
There are certain bellwether companies that because of their sheer size or leadership position are especially worth watching.
Here are three reporting early that may set the tone for the rest of earnings season.
July 17 – Johnson & Johnson (NYSE: JNJ)
Results from this consumer products juggernaut should give investors a clue on how Main Street spending is holding up. The company offers everything from baby care to Band-Aids to over-the-counter drugs, reflecting a broad spectrum of consumer demand.
July 18 – International Business Machines Corp. (NYSE: IBM)
Earnings for this technology giant will reveal spending trends in the world's major economies including Europe, the U.S., China and other emerging markets. IBM will have its finger on the pulse of key company officers who decide whether to open the company coffers for information technology (IT) systems. Its guidance is likely to clearly spell out whether companies are budgeting for upgrades or are canceling spending plans.
July 20 – General Electric Co. (NYSE: GE)
Because this conglomerate has its fingers in so many pies, its guidance always has market-moving potential. The company has dominant businesses in a wide range of industries including medical equipment, electric turbines, locomotives and high finance, to name a few. Its sheer size means GE will set the bar for many important industries.
With U.S. stocks seemingly at a make-or-break moment, what happens over the course of the next few weeks promises to be critical.
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