Santoli: 3 ways bulls can outlast weak earnings

Published Mon, Apr 11 20167:36 AM EDTUpdated Mon, Apr 11 20168:20 AM EDT

When bad news is thoroughly expected, its release can come as relief rather than a jolt. Optimists will say this is why the ugly corporate-earnings news expected to arrive starting this week will be fine for stocks. This is certainly true in pockets of the market, and a run toward the old highs for the Standard & Poor's 500 Index would not be surprising as a reflex response. Yet it's tough to prove that the broad market is fully set up to celebrate a third-straight quarterly decline in profits. S & P 500 companies as a group are poised to report an 8 percent drop in earnings, and the first quarter of 2015 was the last one to show bottom-line growth. It's convenient and telling that the index made its all-time high on May 20 — at just about the time when that first-quarter earnings-reporting season was ending. Since then, after a jarring run of corrections and recoveries, the index is down about 4 percent. This implies that the market has adjusted somewhat to the weakening fundamentals, but in aggregate hasn't lost as much as operating profits have fallen. This leaves the forward price-to-earnings multiple on forecast 12-month earnings near 17: roughly where it was a year ago and the top of the range for this market cycle. Read More Here's how Joel Greenblatt makes 'lots of money' It might help to look at the sector and company breakdown to get a better feel for how the market has reflected the profit pain. Seven of the 10 industry sectors are set to show earnings declines, with only consumer discretionary, health care and telecommunications showing growth. Of the seven sectors with earnings sliding, only three have seen share prices drop over the past 12 months: energy, materials and industrials, with financial stocks flat. Meantime, consumer staples stocks are up an impressive 8.2 percent the past 12 months while profits are set to dip 3.4 percent, as investors bid up stocks perceived as stable and "safer." As a result, these stocks are now looking expensive, and their results won't likely spark even greater strength in share prices. On the flip side, health care is on track to post a 3 percent profit rise, though the sector has shed nearly 5 percent in the past year. The lesson here is that while equities track earnings quite closely over longer time spans, they don't travel in lockstep quarter by quarter or year by year, as the market tries to handicap and reprice for fundamental shifts. And so, investing — or at least, tactical investing — involves trying to anticipate the anticipators and quantify how much companies and analysts have low-balled estimates. It's never fully possible to calculate exactly what profit performance is priced in. Bank of America Merrill Lynch strategists note that companies almost always exceed the final estimates, and consensus forecasts have sagged by 9 percent since the start of the year, twice the typical pace of estimate cuts ahead of earnings season. This could mean that "a bigger beat this quarter is reasonable given this year's dollar weakness, rebound in commodity prices, bounce in the ISM and other industrial indicators, and improvement in global growth," according to the Bank of America report. For what it's worth, the companies set to release results in the coming days seem to be operating under sober investor expectations. Alcoa shares are down 29 percent the past year, no surprise given a nasty collapse in profits. JP Morgan Chase has shed 6 percent, while per-share earnings are projected down 12.4 percent year over year. Wells Fargo and Bank of America shares are down more than earnings are projected to fall. S & P earnings outside of energy are set to fall 3.6 percent. The S & P excluding energy is down a couple percent. Blah earnings, blah market performance — no glaring disconnect there, even if stocks appear quite fully valued given faltering U.S. growth. Read More How to invest in Jamie Dimon's market forecast Anyone seeking to argue the market can catch a fresh lift from here must make one of three bets, or some combination of them: Earnings are bottoming and will catch a second wind. Strategists at JPMorgan note that there have been five cycles since 1900 when profits re-accelerated after a midcycle downturn — one each in the '80s and '90s, most recently. Various macro, policy and corporate factors fed these revivals. Wall Street is, no surprise, already projecting a sharp rebound in the second half. The dollar continues backing off against other currencies, helping corporate profits and taking pressure off the Chinese economy. This is largely a call on the persistently dovish Fed, which first-quarter GDP tracking near zero should arguably support. Even with the fundamental challenges, equities remain relatively attractive and could become even more highly valued. It's worth monitoring the yield on Baa-rated corporate bonds, a proxy for investment-grade credit. These yields are around 4.7 percent, back down to levels last seen in May, which then supported a slightly higher S & P 500. The way stocks respond to the expected ugly reports should give a few clues about how persuasive these arguments will prove to be.

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Brendan McDermid | Reuters

This is certainly true in pockets of the market, and a run toward the old highs for the Standard & Poor's 500 Index would not be surprising as a reflex response. Yet it's tough to prove that the broad market is fully set up to celebrate a third-straight quarterly decline in profits.