What You Need to Know About Earnings

This week holds one of the most significant and important events of the entire year. No, there’s no Fed meeting. And I’m not talking about the virtually endless TV coverage we’ll get from the British Open (though I am pretty excited to get so much action from what’s become my favorite golf tournament). 

The big news is: second-quarter earnings season starts today!!

Yeah, I know, big letdown, right? 

I’m well aware that you’re probably not exactly on the edge of your seat, ticking off the hours until Alcoa (NYSE: AA) kicks off second-quarter earnings season around 4:15 p.m. Eastern today. After all, the whole dynamic for corporate earnings season is pretty, well, non-dynamic. Most companies will manage to beat lowered earnings expectations by a penny or two. Analysts will cheer, the stock prices will rise, and there will be much rejoicing.

That’s basically what’s happened with every quarterly reporting season since mid-2009. 26 consecutive quarters of same-old, same-old…

So you might want to mark today on your calendar — July 11, 2016. Because today is likely to mark an important change for corporate earnings reports. And if you’re not paying attention, you’ll miss it.

A Real Change

If you pay any attention to earnings when they get reported every three months, you know what the big complaints are. For starters, there’s the fact that companies have been spending around $1 trillion a year buying their stock back. This reduces the number of shares outstanding, and that means the all-important earnings per share (EPS) number can grow, simply because there are fewer shares by which to measure earnings. 

Second, this trend of rising earnings per share due to lower share counts has masked the fact that revenue, in general, has been stagnant or in decline for many companies on the S&P 500. 

Most investors focus on earnings per share instead of total revenue. And for the most part, that’s the right thing to do. Because the earnings numbers tell you how efficiently the company is operating. A company can take in all the money in the world from selling its product, but if it can’t turn a profit because it’s getting gouged by its suppliers or it keeps hiring new employees it doesn’t need, well, that means it’s not a good investment. 

But if overall revenue is not growing, it means one of two things: either people are simply not increasing spending, or competition has driven prices lower. Neither is a good sign, because you assume at some point, lower revenue will lead to lower earnings.

This is why the S&P 500 has basically been in a holding pattern for nearly two years, with the occasional downward plunge. Investors have been hoping for the best and preparing for the worst. In other words, they’ve been hoping that revenue picks up, but they’ve been preparing for a drop in earnings.

The irony here is that earnings actually have been falling. For five straight quarters, the companies of the S&P 500 have reported quarterly earnings that are lower than what the company reported for the same period of the prior year. So why haven’t investors simply sold their stock on the evidence that the consumer was weakening and the economy was slowing?

Well, they did at the start of the year. Remember that big 12% sell-off that started on January 1? That was all about falling earnings. 

But there are a couple reasons stocks bounced back and have stayed in a tight range for the most part. Employment gains have remained pretty strong, and the earnings decline has been concentrated in the energy sector. Both of these factors suggest the earnings declines may be temporary and are not indicative of a weak consumer. 

The Recovery Starts Today (We Hope)

Analysts typically keep quarterly earnings estimates at least a year out. They do this not because they expect their numbers to be 100% accurate, but the estimates provide a background against which they can get a handle on valuations (whether stock prices are expensive or not) and also act as a starting point for refining their estimates as they start getting actual sales numbers for a quarter. 

Initial estimates are usually too high, and analysts spend the months before earnings season lowering their estimates to better match the reality of the numbers they are getting. 

But leading into this quarterly reporting season, an interesting thing has happened…

Since April, analysts have lowered their earnings estimates for the S&P 500 by 2.6%. Again, quarterly earnings estimates pretty much always get lowered ahead of each reporting period.

And that’s why ~70% of companies beat earnings every quarter. Lower the bar enough, and everyone can get over and get their Participation Trophy… 

However, research firm FactSet says that this quarter’s revision — down 2.6% — is actually less than the one-, five-, and 10-year averages.

And when you consider that the vast majority of weak earnings are still coming from the energy sector, you have to entertain the possibility that the coming earnings season could turn out pretty good. (As an aside, I’m about the only person who will tell you this. Most just want to tell you how crappy everything is. But numbers are numbers, and I don’t think it’s helpful to comment on the stats you like and ignore the ones you don’t.)

Some economic data has come in positive lately, too. Most recently, the Chicago PMI manufacturing survey came in very strong. Of course, the last Durable Goods report was worse than expected.

So ultimately, what we have is the same as what we’ve had for a while: an uneven and tepid economic recovery, where the best companies are making plenty of money and the Fed is most likely to stay on the sidelines. That formula has been enough to keep a floor under stocks and maintain a generally bullish environment. There’s no reason to think it’s about to change dramatically, at least to the downside. 

Because the fact is, a change to the upside may be brewing. We could actually see some solid earnings growth from the second quarter. And lord knows this market could use some good news…

Now, you’ve no doubt seen that stocks rebounded strongly after the Brexit sell-off. It’s the potential for a really good quarter that’s given stocks such a lift. 

I don’t think most individual investors are aware of how significant this earnings season is. So pay attention: stock prices could be about to head higher. 

Until next time,

Until next time,

Briton Ryle

@BritonRyle on Twitter

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.