'Show-Me' Earnings Could Be Make-or-Break for Stock Rally
CNBC.com Senior Writer
As Wall Street contemplates whether to rally or retreat, third-quarter earnings could be what settles the debate.
That was the case in the second quarter, when the market traded in a fairly tight range for three months but then broke out when July came and earnings showed positive surprises by a nearly 3-to-1 ratio.
Whether the same thing happens in the third quarter is dependent on a variety of factors.
Investors over the summer were happy just to see companies making their numbers by cutting costs, but may not be in such a conciliatory mood this time around.
"Coming out of this we expect the market will be very much in a show-me mood," says John Stoltzfus, senior market strategist at Ticonderoga Securities in New York. "We'll be looking for evidence of signs of growth."
Dow component Alcoa kicks off earnings after the bell Wednesday. Though the company carries the smallest market cap on the bluechip index, its results are seen as the first shot across the bow for how the season will shape up. There are no other significant earnings reports this week, but Johnson & Johnson on Tuesday, JPMorgan Chase on Wednesday and Google and Goldman Sachs on Thursday kick the season into full gear.
Though Alcoa actually beat estimates in the second quarter, early earnings trended lower and the market fell. That trend didn't last long, though, and stocks turned around when company after company beat expectations.
However, most of the beats were accomplished on the backs of heavy cost-cutting—primarily layoffs—rather than revenue growth. That's a trend analysts likely will demand starts to reverse itself for third-quarter reports.
"It's important to see revenue growth. You can only cut so much," says Beth Larson, principal at Evermay Wealth Management in Washington, D.C. "It's also important to see revenue growth that's not just from inventory build. We have to see new demand."
Yet even in that climate, expectations will have to be tempered.
Analysts expect a 23 percent decline in year-over-year earnings and a 7 percent drop from the second quarter for Standard & Poor's 500 companies
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Investors will be watching a few key sectors to use as benchmarks for the earnings season as a whole.
Defensive sectors—consumer staples and health care, among others—are likely to perform the best, while there also are high expectations for multinational companies that should have benefited from the relative weakness of the dollar. The US currency continues to post 12-month lows and is expected to continue to drop until the economy shows more strength.
After leading the market to a more than 50 percent drop from its October 2007 historic high, financials also will be considered an important barometer for Wall Street's health. The news is likely to be a mixed bag.
"We expect more of the same from the bank industry's 3Q09 earnings report and expect year-over-year earnings to fall for the 11th straight quarter—this time by 28 percent," financial services firm Keefe, Bruyette & Woods said in its third-quarter bank earnings preview.
KBW cut its quarterly estimates for nine banks by a median of 17 percent and raised estimates for five institutions. It also cut 2010 estimates for six banks and raised for 10 others.
The conservative outlook was shared by other analysts.
"Revenue should trend modestly lower quarter-on-quarter, driven by flattish spread revenue and moderating fee income trends," analyst David George of Robert W. Baird said in a note to clients.
US Bancorp was among analyst favorites heading into earnings, with positive expectations from both KBW and Baird.
At the same time, many analysts prefer to focus on corporate outlooks going forward rather than rear-view earnings. With the economy struggling to regain its footing, that's likely to be a key again this quarter.
"The key will really be the forward guidance," Jason Roney of Sharmac Capital told CNBC. "Coming out of any recession it's generally been the case that analysts get way too conservative. We are in an upwards revision cycle and when that happens that keeps an underlying floor in stocks no matter what the high-frequency economics data shows."
Should guidance and results both end up less spectacular than the strong second quarter, the result could simply be sideways stock movement until another catalyst comes along.
"I expect guidance to be muted. They're going to say business is looking like the worst is behind us but it's too early to call the rate of incline," says Uri Landesman, head of global growth strategies at ING Investment Management in New York. "I don't think they will be big market movers."