Dicey Earnings Growth Ahead

The stock market rises and falls for many reasons, but in the long run, its direction is primarily driven by earnings and interest rates. Stock prices and corporate earnings are positively correlated, while stock prices and interest rates tend to be inversely correlated.

We’ve talked about interest rates ad nauseam; we know the initial rate hike will come when the data supports it, and we know the market will most likely be volatile but that the economy can weather an initial rate hike or two unblemished. Let’s leave the talk about interest rates at that for today, and move on to earnings.

Corporate earnings have a strong tendency to rise in the absence of an economic recession. Last week the fourth quarter real GDP revision reinforced its previous reading at 2.2%. Not fantastic, and certainly a slower pace of expansion than the previous two quarters, but expansion nonetheless.

Even though the economy continues to expand, US corporate earnings are under pressure as a result of lower oil prices, a stronger dollar, and what appears to be an increased emphasis by consumers on saving rather than spending.

Current estimates are for first quarter corporate earnings to show their first decline since the third quarter of 2012. Thomson Reuters expects S&P 500 earnings to decline by 2.7%. According to FactSet the decline will be near 4.6%.

Not all companies or sectors are expected to post declining earnings growth; as you would expect, the energy sector is dragging overall earnings down heavily, and export-dependent corporations are struggling the most.

Energy sector profits are anticipated to decline around 65%. Other sectors that are expected to see minor earnings-per-share declines are utilities, materials, telecom, consumer staples and technology. On the positive side, healthcare, financials, industrials and consumer discretionary sectors are expected to see continued earnings growth. This data is according to FactSet.

The first and second quarters may see overall earnings decline, but analysts still expect earnings to be positive for 2015 for all sectors except energy. If this turns out to be the case, history suggests the stock market should weather the decline just fine.

Adam Parker, chief US equity strategist for Morgan Stanley, recently pointed out that there have been three scenarios during the last three decades when earnings recessions (two or more consecutive quarters of falling earnings) were not accompanied by economic recessions. In all cases the S&P managed to rise during these periods of profit declines, since there was an expectation for earnings to rebound. The chart below from Thomson Reuters was provided to highlight the periods in question.

Analyst estimates are exactly that … estimates, so we never know what to expect, but so far 85 companies in the S&P 500 have issued negative EPS guidance, and only 16 have issued positive guidance. We could be in for a tough earnings season and if that’s the case, there’s a good chance more choppy trading lies ahead for stocks.

The chart below shows the ratio of the small-cap Russell 2000 index to the large-cap S&P 500. I’ve been pointing out the upward nature of this relationship, which indicates small-caps have been outperforming their larger and more internationally exposed counterparts, for some time now.

This trend has been in force primarily as a result of smaller companies having less exposure to the impact of a strengthening dollar.

In their latest report, FactSet performed a different analysis that yielded a similar result. They broke the S&P 500 companies into two groups, those that generated more than 50% of their sales abroad, and those that generated less than 50% of their sales abroad. They then examined how the stock prices of those respective groups has performed YTD (through March 26th).

As you would expect, they found that investors are favoring companies with less foreign exposure. During that time frame, the S&P 500 was up 0.6%. The group of companies with more than 50% of their sales abroad declined by 1.8%, while the group of companies with more domestic exposure rose by 1.5%. That’s roughly a 3% outperformance over the course of only three months.

With markets so consistently erratic, it’s nice when an analysis actually yields the result that would be expected. The takeaway is that investors continue to (mildly)dismiss companies with heavyexposure to non-dollar denominated sales. This trend is likely to persist if the dollar continues its march higher.

The market is back in rally mode today with the Dow up nearly three hundred points. A strong opening on the heels of European strength, a host of biotech M&A activity, and signs of more easing and infrastructure spending ahead in China, paved the way for gains across the board. While a nice relief from last week’s slide, it’s probable that much of today’s action is end-of-quarter window dressing. This refers to the process by which portfolio managers dress up their holdings in preparation for quarterly reporting.

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