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Taking stock of S&P earnings

Henrik Jonsson | E+ | Getty Images

Now that we are almost through second-quarter earnings season, we thought we'd make an attempt at drawing some conclusions. According to Bloomberg, 87 percent of the companies in the S&P 500 have reported at this point.

Seventy-two percent of those companies beat the consensus estimate for earnings per share, and 56 percent beat the consensus estimate for revenue. Those results compare with 3 percent and 49 percent, respectively, in the first quarter. In the second quarter, the average beat relative to estimates has been 2.7 percent for EPS and 0.4 percent for sales.

In the first quarter, the average beat on EPS was 5 percent, while the average revenue miss was -0.5 percent. None of these numbers strike me as wildly surprising. As is usually the case, companies were able to beat the conservative EPS guidance provided by management. But revenues are coming in modestly ahead of expectations for the second quarter versus modestly below in the first.

(Read more: Investors plug back in after Tesla earnings surprise)

The more interesting conclusions might be gleaned looking at year-over-year growth in earnings per share and revenue.

According to Bloomberg, average EPS growth for S&P 500 companies that have reported so far is 4.1 percent. It was 1.9 percent in the first quarter. Average revenue growth has been 1.7 percent, versus -0.8 percent in the first quarter.

On the surface, it appears that growth in both EPS and revenue accelerated sequentially in the second quarter. This is obviously a good thing, but we wanted to better understand the source of this acceleration. Therefore, we looked at the growth rates in EPS and revenue by industry sector. The tables below show that data.

EPS Growth

Sector
2Q
1Q
Energy -8.4% -4.4%
Materials -11.6% 0.6%
Industrials -1.3% 0.3%
Consumer Discretionary 10.7% 3.7%
Consumer Staples 5.2% 5.6%
Health Care 1.2% -0.4%
Financials 28.1% 8.4%
Info Tech -4.8% -2.2%
Telecom -1.1.% 4.7%
Utlities 6.3% 10.5%
Total 4.1% 19.%
Source: Bloomberg

As the table shows, the financials sector was most responsible for the acceleration in second-quarter EPS and revenue growth. Financials put up 28.1 percent growth in EPS and 8.6 percent growth in revenue.

(Read more: Groupon revenue jumps 7%, helped by mobile)

Given that financials account for about 16 percent of the total S&P 500, it is easy to see why the sector was responsible for the positive overall growth in S&P 500 earnings in the quarter.

In fact, by our back-of-the-envelope analysis, EPS growth for the overall S&P 500 would have been much closer to 0 percent if not for financials.

Why is this important? Because the financials sector is largely composed of banks and insurers, and earnings at these types of companies are heavily influenced by loss provisions that won't be proved adequate until perhaps years into the future.

During the financial crisis, banks were forced to dramatically increase their loan-loss reserves to cover bad loans. These additions (through quarterly provisioning) resulted in severely depressed earnings, if not outright losses, at many banks.

Now that the financial crisis has passed, banks are by and large reducing their loan-loss provisions and reserves. The net effect is that bank earnings and year-over-year earnings growth are much higher than they would be in the absence of lower loss provisioning.

Suffice it to say that this accounting gimmickry, which has been going on for several quarters, has contributed greatly to overall S&P 500 earnings growth. At some point, banks will no longer be able to rely on this source of earnings.

(Read more: Green Mountain earnings beat, revenue falls short)

Revenue Growth

Sector
2Q
1Q
Energy -8.5% -18.5%
Materials -1.0% -3.1%
Industrials 1.0% 0.1%
Consumer Discretionary 7.1% 5.1%
Consumer Staples 1.5% 1.8%
Health Care 3.4% 5.0%
Financials 8.6% 2.9%
Info Tech 2.2% 3.1%
Telecom 3.1% 1.0%
Utilities 9.9% 6.0%
Total 1.7% -0.8%
Source: Bloomberg

Consider the case of Capital One Financial, a bank within the S&P 500 that reported a 500 percent increase in EPS in the second quarter. The company could achieve this huge growth rate in because of a $915 million decrease in its loan-loss provision. For perspective, that decrease was equal to about 50 percent of second-quarter pretax earnings.

In the absence of this decrease in loan-loss provision, the company's EPS growth would have been much more modest. And while Capital One represents the most extreme example of EPS growth through lower loss provisioning, banks throughout the S&P 500 are generating outsized earnings growth the same way.

(Read more: Mondelez beats on earnings, raises dividend)

Optimism about the economy and corporate earnings growth has risen recently, leading to speculation that the Fed will begin to "taper" its massive monetary support by year-end. We think the optimism may be getting ahead of the fundamentals.

Corporate profit margins are running at all-time highs, and revenue growth remains constrained. Based on these factors, earnings estimates for 2014 may prove to be too high.

At this point, we think we are in the "show me" stage for stocks. Companies must demonstrate an ability to increase the bottom line through revenue growth, because opportunities for margin expansion are getting smaller and smaller.

—By Michael K. Farr, President of Farr Miller & Washington and CNBC Contributor