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Why Weak Earnings Outlook Could Actually Help Stocks

Monday, 9 Jan 2012 | 2:02 PM ET

A downbeat earnings season forecast could be just the remedy the stock market needs to break out of its winter doldrums, at least if history holds true.

With analysts expecting profit growth well below the elevated levels that recent quarters have bestowed, positive surprises, in which corporate America would show that it has weathered the debt crisisin Europe and U.S. political instability, would go a ways toward restoring investor faith.

Earnings season kicks off officially when Dow component Alcoa reports after the closing bell Monday.

"There's an old rule of thumb that the more negative you are going into earnings season, the more negative preannouncements there are, the more it allows for the possibility of positive surprises and therefore money to go in the market," said Quincy Krosby, chief market strategist for Prudential Annuities in Newark, N.J.

A market essentially unchanged since late October and, for that matter, the entire past year could use a jolt.

"When everyone believes earnings and guidance are going to be strong, the money will already be in the market," Krosby said. "If you start to see some of the leadership come out with positive surprises and guidance, which will be very important for this market, you will see short-covering and that brings positive momentum for the markets."

Current estimates for fourth-quarter profit show a 7.2 percent increase in earnings per share, well below the previous quarterly gains of 19.7, 19.2 and 17.6 percent. Earnings are expected to rise for seven of 10 sectors in the Standard & Poor's 500 .

"Guidance, therefore, will be key on deciding whether the S&P 500's early-year advance has a fundamental basis for sustainability," Sam Stovall, S&P's chief equity strategist, said in a research note.

Stovall offers a strong caveat, though, for the muted earnings projection: Estimates on average for 2011 were 55 percent below the final number, meaning that if the pattern holds the final quarter actually could see an 11 percent increase in profit.

Most analysts, though, aren't expecting much.

On the S&P 1500, analysts have raised projections for 366 companies but lowered for 534, an 11.2 percent difference, and all 10 S&P sectors have had more negative revisions than positive, according to Bespoke Investment Group. However, history presents another interesting guide.

At the onset of 2010, analysts were positive for eight of the 10 sectors, with the only net negative revisions coming for health care and utilities. The two best-performing sectors for 2011, of course: Health care and utilities.

"Hopefully, the across-the-board negative sentiment on the part of analysts heading into 2012 will simply set the expectations bar low," Bespoke's Paul Hickey said.

To be sure, there's always the possibility that analysts could be justified in their pessimism.

The two leading sentiment surveys — the American Association of Individual Investorsand Investors Intelligence — are showing strong bullish readings nearing 50 percent that often indicate an overbought market ready for a selloff.

Earnings Season Best Bets
A look at what traders can expect given all the pre-announcements and the best plays right now, with Mike Holland, Holland & Company and Ned Riley, Riley Asset Management CEO.

And the market faces persistently strong headline risk, much like the beginning of 2011 when European fears had been shelved only to re-emerge strongly in ensuing months and squelch a rally that began in late-summer 2010.

Capital Economics said there are signs that the profit cycle which accelerated last year is starting to show signs of tiring and margins are stretched. A drop in labor expenses that probably has run its course will curtail the types of aggressive earnings gains companies were showing, said Capital's senior market economist John Higgins, who believes the S&P will finish the year lower at 1150 and that quarterly earnings actually could show a decrease.

"Even if we are wrong and the profit share does edge higher, though, we are not convinced it will propel the stock market higher," Higgins said. "Valuations are not especially compelling from a historical perspective and the crisis in Europe is likely to continue to curb investors’ enthusiasm for risk."

Indeed, despite the bullishness in sentiment surveys equity funds have seen outflows for 19 consecutive weeks.

Better-than-expected results off tepid expectations, though, could be just the incentive to get money put to work again.

"The question for investors is whether these macro concerns and geopolitical concerns trump the fundamentals from corporate America," Krosby said. "We still believe they will be solid. They just won't be as good. The question is by how much."

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