Santoli: The earnings recession is ending

Published Sun, Jul 10 20169:26 PM EDT

The "earnings recession" is ending. But will this be enough to provide an added boost to a stock market that has survived the profit downturn intact, borrowing its strength from bonds while becoming no cheaper in the process? As reporting season gets rolling this week, the consensus forecast for S & P 500 companies' second-quarter earnings is a decline of 5.6 percent from a year earlier, according to FactSet. This would be the fifth straight quarter of lower year-over-year profits. The "typical" quarter sees companies in aggregate report better-than-expected numbers, with the average margin of upside running around four percentage points. If the pattern persists, companies have an outside shot of ending about even with the 2015 period. The current forecasts for the third quarter are for a slight dip of less than 1 percent in profits, followed by a more notable bounce-back in the fourth quarter. So, one way or another, the prolonged contraction in Corporate America's profitability appears set to end within either weeks or months. Most of the rebound owes to the passage of time: We are moving beyond the effects of the oil crash and U.S. dollar surge that took hold early last year. Thomas Lee of Fundstrat Global Advisors, sees a few other encouraging clues pointing to a sturdier fundamental outcome during this profit season. The pace of positive company "preannouncements" for the quarter is the highest since early 2011 and the rate of downside warnings the lowest since the same quarter. Lee also points out that the ISM manufacturing survey's exports component is back in growth mode, and corporate interest costs have fallen more as the bond market has rallied. Is it strange that Wall Street is heralding the end of more than a year of weakness in corporate performance, while the broad stock market appears no worse for the ordeal? With Friday's surge after a reassuring employment report, the S & P 500 closed within a point of its all-time closing high – set in May 2015, right before the earnings recession began. It's as if someone emerged from a long illness having lost no weight, missed only a few days of work and took a couple of vacations along the way. Source: Sectorspdr.com This impression is complicated by a look below the index's surface. Sectors most geared to global growth and financials shackled by ultra-low interest rates have truly been sick. The energy, basic-materials, transportation and financial sectors are all still down between 10 and 18 percent from their respective early-2015 highs. As has been universally discussed by now, the stocks that look and act most like bonds - with reasonably steady businesses and decent dividend yields - have supported the market for many months now. The consumer-staples, utilities, telecommunications sectors combined are now larger than financial stocks in the S & P 500, making it a greater beneficiary of collapsing global bond yields than it used to be. Another thing to note: The earnings recession was a grinding irritant to stocks but was not terribly severe. The year-over-year declines by quarter were 3 to 8 percent, and quarterly per-share S & P 500 profits stayed between about $27 and $30 over than span. On an annual basis, if the latest 2016 forecast of $118.82 in earnings is near the mark it will mean the third straight year between $117 and $119. So, flat earnings, flattish market. So if this, roughly, is the baseline earnings power at this point, with a chance for a modest upturn heading into 2017, what does it mean for the prospects for stocks themselves now sitting near a record? The bullish inference is this: Stocks were fully valued in May 2015, not priced for a profit downturn. But while the cyclical sectors rolled over in response, the stable dividend groups took the lead and held things together. We had "rolling bear markets," but without a rise in market interest rates or a U.S. recession, it was merely a severe correction rather than full-blown bear market. As it stands now, numerous asset classes are at all-time highs on a total-return basis (including dividends and interest): Every sort of bond, large-cap U.S. stocks, real estate investment trusts, high-momentum stocks and low-volatility stocks. Source: Pension Partners The S & P 500 at the May 2015 high traded near 17-times forecast earnings for the next 12 months. We are now at 16.6-times forward earnings. So equities didn't get much cheaper. Yet we now know just how over-optimistic those estimates were 14 months ago. The earnings shortfalls that followed meant that the S & P was in fact trading at 18.2-times forward profits. So, if today's forecasts are any closer to reality (a plausible, but hardly certain outcome) then stocks are substantially less expensive than they were the last time the index was up at today's levels, at a time when corporate bond yields are much lower. And it would mean the groups more levered to economic conditions – consumer cyclicals, industrials and materials – can perhaps catch up a bit. Yet this brings up the chance that all we might get, even if earnings come in stronger, is another rotational market, money flowing from the overheated yield stocks into cyclicals with little net progress for the broad market. Then again, if Treasury yields continue refusing to lift even on better economic news, maybe the "everything rally" can continue – cats and dogs reconciling, the jocks and the nerds line dancing together at the prom. This might seem a tortured scenario to bet on with real money, given the uncomfortable realities of negative bond yields, a mature economic cycle, impairment of developed-market banks and the near-forced purchase of risky assets by deflation-fighting central banks. And, true, in the short term trader sentiment is getting a bit overconfident both in stocks and in Treasury bonds, which hints at gut checks to come. Yet with regained momentum, the volatility fever broken for now and the cover story of rebounding earnings in the offing, wouldn't it be perfectly logical for stocks, finally, to tack on a bit more upside after some 18 months of diffident side-winding?

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The "earnings recession" is ending.

But will this be enough to provide an added boost to a stock market that has survived the profit downturn intact, borrowing its strength from bonds while becoming no cheaper in the process?

As reporting season gets rolling this week, the consensus forecast for companies' second-quarter earnings is a decline of 5.6 percent from a year earlier, according to FactSet. This would be the fifth straight quarter of lower year-over-year profits.

The "typical" quarter sees companies in aggregate report better-than-expected numbers, with the average margin of upside running around four percentage points. If the pattern persists, companies have an outside shot of ending about even with the 2015 period. The current forecasts for the third quarter are for a slight dip of less than 1 percent in profits, followed by a more notable bounce-back in the fourth quarter.

So, one way or another, the prolonged contraction in Corporate America's profitability appears set to end within either weeks or months. Most of the rebound owes to the passage of time: We are moving beyond the effects of the oil crash and U.S. dollar surge that took hold early last year.

Thomas Lee of Fundstrat Global Advisors, sees a few other encouraging clues pointing to a sturdier fundamental outcome during this profit season. The pace of positive company "preannouncements" for the quarter is the highest since early 2011 and the rate of downside warnings the lowest since the same quarter. Lee also points out that the ISM manufacturing survey's exports component is back in growth mode, and corporate interest costs have fallen more as the bond market has rallied.

Is it strange that Wall Street is heralding the end of more than a year of weakness in corporate performance, while the broad stock market appears no worse for the ordeal?

With Friday's surge after a reassuring employment report, the S&P 500 closed within a point of its all-time closing high – set in May 2015, right before the earnings recession began. It's as if someone emerged from a long illness having lost no weight, missed only a few days of work and took a couple of vacations along the way.