Earnings Season: Here We Go Again

by Brad McMillan, CIO, Commonwealth Financial Network

This morning, I spent some time speaking with a client who wanted to know why markets had slowed down recently. But I am not sure I agree with her. We hit all-time highs just the other day, although in recent days, the market has been taking a bit of a breather. Will that down time continue, or could we get another leg up?

I suspect the reason for the current caution is due to the fact that earnings season is now underway. Stocks ran up over the past couple of weeks on an increasing belief that a Fed rate cut was in the offing for July. Indeed, that does appear to be the case. With that cut priced in, however, markets are now looking for another reason to rise. With the expectations for earnings as modest as they are, though, the data so far isn’t providing that support.

Declining expectations

According to FactSet, second-quarter earnings are supposed to decline, which would mark the second consecutive quarter of declines. Two consecutive quarters of decline is commonly known as an “earnings recession,” and this would be the first one since the first two quarters of 2016. Worse, expectations have declined over the past quarter. At the end of the first quarter, second-quarter earnings were expected to be down by only 0.5 percent. Now, they are down to an expected decline of 3 percent. That’s a big drop, driven by the second-highest number of companies issuing negative guidance since 2006. 2006!

Despite all that negativity, during the quarter, stocks went up. Even as earnings expectations were dropping, even as companies were being publicly discouraging about their prospects, stocks rose.

What about the markets?

I think this picture gives us some guidance as to what earnings season is likely to mean for the markets over the next couple of months. Investors seem to be willing to buy stocks, at rising prices. Why? First, because as interest rates drop, stocks become more attractive. Second, because despite the poor expectations, actual earnings results often come out better than expected.

For the first point, with interest rates down substantially, an upward adjustment to valuations more than offset the decline in expected earnings growth. The tide was rising, so a little more ballast still kept the boat floating higher. As long as rates remain low, we can expect current valuation levels to hold, leaving the market supported at current levels.

For the second point, while expected earnings growth is down, that expectation comes from economic growth fears combined with those company guidance reports we discussed. In other words, lower growth assumes that most of what is feared will actually go wrong—and that’s a lot of stuff. Small wonder earnings are expected to decline.

Data versus fears

But when we look at the actual data versus fears, the outlook is better than expected. Today, consumer spending in the form of retail sales came in much stronger than anticipated. This result suggests that with job growth still solid and confidence high, the major component of the economy remains strong. Although there are signs that growth is slowing, it was still solid in the second quarter—which would support earnings.

Corporate expectations and guidance, which assumed weaker performance, will therefore likely be too pessimistic. More than that, companies have an incentive to be as downbeat as reasonable. By lowering the bar, they give themselves an easier target to beat. With all of the reasons to worry, it is not surprising that a very high number of companies took advantage of that atmosphere.

We see this scenario in the data as well. On average, about three-quarters of companies beat expectations by about 5 percent, which suggests they were too low to begin with. The combined effect is that earnings growth usually comes between 3 percent and 4 percent higher than expected.

Will earnings beat expectations?

With markets priced for slower growth, faster growth should be a tailwind. With markets priced for a meaningful earnings decline, a smaller decline—or even growth—would be another tailwind. There are good reasons to believe that despite the downbeat expectations, earnings season could come in better than expected—which would be good for markets.

As always, we will see. But don’t panic over the headlines just yet.

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Brad McMillan is the chief investment officer at Commonwealth Financial Network, the nation's largest privately held independent broker/dealer-RIA. He is the primary spokesperson for Commonwealth's investment divisions. This post originally appeared on The Independent Market Observer, a daily blog authored by Brad McMillan.

Forward-looking statements are based on our reasonable expectations and are not guaranteed. Diversification does not assure a profit or protect against loss in declining markets. There is no guarantee that any objective or goal will be achieved. All indices are unmanaged and investors cannot actually invest directly into an index. Unlike investments, indices do not incur management fees, charges, or expenses. Past performance is not indicative of future results.

Commonwealth Financial Network is the nation's largest privately held independent broker/dealer-RIA. This post originally appeared on Commonwealth Independent Advisor, the firm's corporate blog.