Trader Talk

Is the profit recession about to end?

Saul Gravy | Getty Images

It's a well-worn piece of Wall Street mythology by now: We are in a profits recession.

The has seen four consecutive declines in quarterly earnings. First quarter 2016 earnings are expected to be down roughly 8 percent, following a 3.8 percent decline in the fourth quarter of 2015.

There's a reasonable shot that might be about to change, however, and that may be a motivating factor in the markets march toward historic highs.

That's right — historic highs, because we are very close. The Dow passed 18,000 yesterday, a mere 300 points from the closing high of 18,312 on May 19 of last year. The S&P 500 is less than 40 points from its historic high of 2,131, as well.

Earnings, and more importantly second-quarter guidance, are the key to pushing the markets to new highs. Financials rallied last week as the biggest banks reported modest gains in loan growth, despite flat net interest margins. A little better than expected was enough to move this unloved group up.

Now it's the industrials' turn. The sector will begin reporting this week, with reports from big names such as Honeywell, Caterpillar, Illinois Tool Works, and General Electric.

Any sort of collective positive commentary, or even "less bad" commentary, could propel the industrials slightly higher and push the markets into record territory.

Remember, the market looks ahead. What's important are second-quarter earnings estimates, not first-quarter estimates. And here is where the estimates are right now:

S&P 500 earnings estimates (source: Factset)

Q2: down 2.9 percent

Q3: up 3.5 percent

Q4: up 10.7 percent

A key point is that downward revisions for the second quarter have dramatically slowed; there is a reasonable shot we may only be down roughly 3 percent going into the end of the quarter.

Traders: These stocks will shock in earnings

That's important because, collectively, companies usually beat by roughly three percentage points. That means there is a reasonable shot the final second-quarter number will be positive, putting an end to the earnings recession.

Transitioning from negative earnings to flat earnings does not sound like a cause for a party, but it is important because it marks a change in the narrative.

Remember why the market has rallied in the past two months:

  1. the Fed's dovishness has put a "floor" under the market,
  2. the dollar has weakened,
  3. oil has come off its lows and increasingly appears to have put in a bottom, and
  4. China has quieted down.

The missing ingredient has been earnings. The market seems to believe that earnings estimates have been cut too much, and that the Fed and oil will change the narrative.

See why the Street is starting to get excited?