Originally posted at Briefing.com
The third quarter earnings reporting period is about to shift into high gear, only it isn't expected to produce a whole lot of speed. In fact, the current consensus earnings per share (EPS) growth projection from S&P Capital IQ indicates third quarter EPS is expected to decline — not decelerate, but actually decline — 5.1%.
While the stock market has certainly had its troubles in recent weeks, the past week or so has been imbued with a bullish bias leading up to the reporting period. Several factors have facilitated the turn in sentiment, but with respect to the earnings picture specifically, market participants have seemingly tempered their earnings worries on account of the following:
- They are armed with an understanding that, historically, actual EPS growth has almost never been as bad as expected
- They have been dismissive of the projected decline because they know it is driven by the energy sector
- They have maintained their tunnel vision on the six-month EPS growth outlook which looks much rosier than the here and now; and
- They sense the bad news was more than priced in with the late-August selloff that triggered the first 10%+ pullback in the market in four years
Yes, it's earnings reporting season alright when there is an increased inclination to view the bad as better than feared, the good as great, and the ugly as just plain ugly.
Writing on the Wall
The dip in the S&P 500 to 1867 in late August was precipitated by growth concerns that were rooted in China's slowdown, deflation worries, and the unsettling recognition that the real economy continues to sputter despite the world's leading central banks doing all they can to get it cranking.
Things have healed in the capital markets somewhat since then, yet the writing of the economic difficulties has been on the wall of downward earnings revisions. To that end, every sector, with the exception of the telecom services sector, has seen EPS growth expectations come down since July 1. As an aside, the uptick for the telecom services sector has a lot to do with DirecTV now being counted as part of AT&T's operations.
| Sector | July 1 | Today |
|---|---|---|
| Consumer Discretionary | 14.7% | 11.8% |
| Consumer Staples | -0.4% | -3.2% |
| Energy | -59.3% | -65.8% |
| Financials | 9.9% | 3.8% |
| Healthcare | 8.8% | 7.0% |
| Industrials | 4.3% | 1.0% |
| Information Technology | 4.5% | -0.2% |
| Materials | -0.7% | -14.5% |
| Telecom Services | 6.5% | 9.5% |
| Utilities | 1.8% | 0.6% |
| S&P 500 | -1.0% | -5.1% |
Source: S&P Capital IQ
Something else that has come down since July 1 is the S&P 500 itself. At current levels, it is about 4.0% lower than it was when the month of July began.
We touched above on some of the issues that contributed to the retreat, yet the overriding fundamental concern from then until now is that both sales and earnings growth has been faltering on the back of a stronger dollar, plunging commodity prices, weakness in emerging markets, restraints in both business and consumer spending, uncertainty about when the Federal Reserve will raise the target range for the fed funds rate, and volatility in the capital markets.
[Read: Bear Market Devil Might Be Lurking in the Details]
These concerns aren't entirely new. They were discussed in previews leading up to the second quarter reporting period, which wasn't necessarily great but was certainly much better than feared. To be exact, second quarter EPS growth was 0.1% versus a 4.4% decline that was expected before the start of the reporting period.
The real relief point, though, was the understanding that second quarter EPS growth was 7.9% excluding the energy sector.
The Ex Factor
Once again, there is a willingness to discount the expected weakness for third quarter earnings as being an "energy thing." Remove the energy sector from the equation and third quarter EPS growth would be 2.8%, according to S&P Capital IQ.
Generally speaking, the final EPS growth rate often comes in two to three percentage points better than the final estimate before the reporting goes into full swing. One can see, then, why a market that is quick to look for a silver lining in the earnings reporting period doesn't think a projected 5.1% decline in third quarter EPS growth is as concerning as it looks at first blush.
We don't take such exclusions lightly. In fact, we don't entertain the exclusions.
The economy is cyclical. Some periods are better than others — much better — and some are worse — much worse. If you exclude things when they are really bad, then they should be excluded when things are really good — only the exclusion of the really good never happens.
It's all relevant and it all counts in good times and in bad for determining the valuation of specific sectors and the market overall. With that, our unrelenting argument is that the base for determining how third quarter EPS growth measures up to prevailing expectations is -5.1%, not +2.8%.
A Stark Forecast
Turning our attention to the revenue outlook. Consensus estimates certainly aren't measuring up all that well.
Third quarter revenue for the S&P 500 is expected to decline — not decelerate, but actually decline — 1.1%. If that ends up being the case, it would be the third straight quarter of revenue declines, which is something that hasn't happened since 2009.
That last point is a stark one knowing what the world was dealing with in 2009. A lot of the expected weakness is again being pinned on the energy sector, which is projected to see revenues decline 30.9%, as well as the stronger dollar.
[Listen to: Technician Tom McClellan: Bear Market Trend Should Last Until Next April]
For some currency comparison perspective, consider that the average value of the Federal Reserve's Nominal Broad Effective Exchange Rate Index in the third quarter of 2015 was 114.03 versus 103.22 in the third quarter of 2014.
You can bet you'll hear a lot about currency exchange creating a headwind for multinational companies in the third quarter. It will likely factor into the fourth quarter guidance as well knowing that the average value of the Exchange Rate Index in the fourth quarter of 2014 was 108.07. By the same token, it's possible we'll start hearing companies point to the prospect of currency headwinds lessening in coming quarters as the comparisons ease.
We'll know what we know when we hear it, but for the time being, here is what we know about the third quarter and fourth quarter revenue projections:
| Sector | Q3 Revenue Growth | Q4 Revenue Growth |
|---|---|---|
| Consumer Discretionary | 8.7% | 8.1% |
| Consumer Staples | -1.4% | -1.3% |
| Energy | -30.9% | -26.4% |
| Financials | 4.1% | 4.6% |
| Healthcare | 10.1% | 10.0% |
| Industrials | 2.1% | 2.2% |
| Information Technology | 1.1% | 1.8% |
| Materials | -11.5% | -8.0% |
| Telecom Services | 14.5% | 15.5% |
| Utilities | 2.8% | -1.7% |
| S&P 500 | -1.1% | 0.3% |
Source: S&P Capital IQ
What It All Means
Regular readers will know that our market return outlook for 2015 has revolved around the trend in earnings estimates. Those estimates have been coming down, such that the projected EPS growth rate for all of 2015 now stands at -0.8%.
With the latter in mind, we have said that we don't expect much price return for the S&P 500 this year and recently allowed for the possibility that this will be a down year for the S&P 500.
We're anxiously waiting for a change in the earnings estimate trend that is supported by a change in the trend for global economic activity.
Both have been disappointing so far this year.
Over the course of the next four weeks or so, we'll learn if the third quarter reporting period, which will be replete with fourth quarter guidance, can lessen that sense of disappointment.
