Analysts project profits for S&P 500 companies to rise 10 percent, according to the consensus estimate compiled by Thomson Reuters. Given analysts' propensity to underestimate and corporations' tendency to over-deliver, actual earnings could turn out to be better than forecast.
This trend has already started, according to Dirk van Dijk at Zacks. My former colleague calculates that positive profit surprises are outnumbering negative ones by a ratio of more than 3:1. Only a small fraction of all S&P 500 members have reported, however, so the ratio will change.
Shareholders of individual companies want good news at the micro level, in addition to the macro level, and this where things could get a bit more troublesome. Thomson Reuters says the ratio of negative-to-positive earnings preannouncements is 2.6. The ratio was 1.8 for the first quarter of 2011 and 1.2 for the second quarter of 2010.
In other words, a higher proportion of large-cap companies warned that profits won't be as good as originally thought for the most recently completed quarter compared to last quarter and the same quarter one year ago.
Executives will have a long list of excuses to point to should their companies' profits not be as good as shareholders had hoped. Among the excuses will be disruptions caused by disaster in Japan, bad weather in the U.S., higher commodity prices and the economy.
For some companies these will be legitimate reasons as to why profits were disappointing; for others, it will be a way of covering up poor execution.
It is not often clear where the influence of external factors ends (e.g., slowing economic growth, higher commodity prices, etc.) and where failure by management begins. A look at competitors' earnings reports and financial statements can give some insight, however. You will want to compare changes in revenues and earnings growth rates as well as changes in profit margins.
External factors should impact revenues and profits for several related companies. If the company you are invested in disappoints and its peershad a good quarter, the problem could be with company itself--regardless of what the executives would like you to believe.
When evaluating earnings, you should also consider the reason you bought a stock. If you bought a stock for its growth characteristics and the rate of growth is showing signs of slowing, that would be a cause for concern. (This would particularly be the case if it looks like internal factors had an adverse affect.)
Conversely, if you bought a stock because the valuation was cheap, a merely decent (as opposed to a great) report might be acceptable. In either case, be wary if profits are falling and are at risk of falling again next quarter.
Stocks, Earnings and Washington, D.C.
July has historically been an okay month for stocks. Presuming that most companies do top expectations, it would seem that the markets should react positively. Plus many stocks went on sale last month, though the late-June rally removed a good part of the comparative discounts.
The big elephant in the room, however, is the debt ceiling. I cannot predict when our elected officials will reach an agreement, though it does seem that some progress has recently been made.
The danger of selling stocks now with the intention of getting back in after an agreement has been reached is that you could miss out on any gains that do occur between now and then. Yes, you might also avoid any downside volatility, but it will take a better crystal ball than mine to predict how the markets will react between now and the August 2 deadline for raising the debt ceiling.
This Week's Gratis Tip
Corporate profits are often judged relative to expectations. Did the results for the most recent quarter exceed or miss analysts' forecasts? How does the company's guidance for future profits compare to the consensus forecast?
The reason traders ask these questions is because stock prices are based on expectations for future earnings. Changes in projections can lead to a change in a stock's price. Earnings Estimates and Their Impact on Stock Prices explains what earnings estimates are and the role they play in influencing a stock's price.
The Week Ahead
Second-quarter earnings season will officially start on Monday afternoon, when Alcoa reports. Joining the aluminum company will be fellow Dow component JPMorgan Chase, which reports on Thursday. A total of 10 S&P 500 member companies are currently scheduled to release quarterly results, including Citigroup on Friday.
The week's first economic reports will be the May international trade report and the minutes from the June Federal Open Market Committee meeting on Tuesday. Wednesday will feature June import and export prices.
The June Producer Price Index (PPI), June retail sales, and May business inventories will be released on Thursday. Friday will feature the June Consumer Price Index (CPI), June industrial production and capacity utilization, the preliminary July University of Michigan consumer sentiment survey and the July Empire State Index.
Fed Chairman Ben Bernanke will testify before a House of Representatives committee on Wednesday.
The Treasury Department will auction $32 billion of three-year notes on Tuesday, $21 billion of 10-year notes on Wednesday and $13 billion of 30-year notes on Thursday.
Charles Rotblut, CFA is a Vice President with the American Association of Individual Investors (http://www.aaii.com) and editor of the AAII Journal.