The "earnings recession" may be about to end. Here's why.
On the surface, the news continues to be gloomy. The "earnings recession" continues — for the moment. Third-quarter earnings for the S&P 500 are set to decline 0.5 percent compared to the same period a year ago.
If that stands, it will be the fifth consecutive quarter of earnings decline for the S&P 500, its worst showing since 2007-2009, when there were nine consecutive quarters of negative earnings growth, according to Thomson Reuters. Energy will lead the decline again, with a decline of 66 percent from the same period a year ago.
But there's a good chance that will all change.
First, the 0.5 percent decline is so small that there's a good chance this can reverse and go positive by the time all 500 companies report. That's because analysts tend to be overly optimistic on earnings going into the quarter, cut their estimates once they are in the quarter, and then companies tend to beat the estimates by a small amount. How much? On average, earnings are typically about 3 percentage points higher than analyst estimates at the end of the quarter. So if history is any guide, third quarter earnings should come in UP about 2.5 percent.
Here's even better news: After six straight quarters of revenue declines, the third quarter will see a revenue gain of 2.6 percent, the first quarter of growth since the fourth quarter of 2014.
And revenue growth is broad-based: 9 of the 11 S&P sectors are expecting growth, with notable gains expected from Consumer Discretionary, Health Care and Technology.
Revenue growth leaders
Source: Thomson Reuters
That is critical because revenue gains (top-line growth) tend to lead earnings gains (bottom-line growth).
Simply put, revenue growth has the potential to finally kill the earnings recession.
I want to focus on technology, because it is the only sector where earnings estimates were RAISED through the quarter.
Why? Because revenues are growing for several critical sub-sectors:
Q3 technology revenue growth (ests.)
Wow. Double-digit gains. What's going on?
More interesting is the enormous product up-cycle in semiconductors and the equipment manufacturers that make them. Broadcom, Intel, Micron, NVIDIA, Xilinx and the companies that actually make the semiconductors (Applied Materials, KLA-Tencor, Lam Resarch) are the beneficiaries of the need for new memory chips in phones and virtual reality devices, as well as the drive for chips that use less energy and are less draining on batteries. Then there's cloud technology and the relentless need to store more data. It all requires bigger and faster chips!
And the slow-growth group? Hardware Storage & Peripherals, which includes not only slow-growth stocks like Seagate, Western Digital, Hewlett Packard Enterprises, but also Apple, which will likely report a roughly 14 percent decline in revenues for the third quarter.
It's not just technology with stronger revenue gains overall. Several health care sectors will also have strong gains. Pharmaceuticals, the largest sector, will report respectable revenue gains of 5.0 percent, with especially strong revenue gains from Bristol-Meyers (up roughly 17 percent) and Johnson & Johnson (up roughly 6 percent). Managed health care, consisting of HMOs like Aetna and Cigna, are also reporting strong revenue gains of roughly 11 percent.
The one big drag, of course, is energy, with revenues down 11.2 percent. Take out energy and the S&P would be reporting an earnings gain of 4.1 percent rather than a decline of 0.5 percent.
But even here there is some light at the end of the tunnel. The biggest oil companies (ExxonMobil, Chevron, Occidental Petroleum) will collectively see revenues down only 5.7 percent, though earnings are still down a whopping 44 percent.
What this tells us is that big oil has a cost control problem. You still have revenue even with oil at $40, but your profits can go negative very quickly. When oil gets down below $40 — as it did at the end of July — that puts big pressure on profits. Oil above $40 and closer to $50 will be a big help, which is why revenues look like they are going to be a lot better in the fourth quarter.
Bottom line: I see strong revenue gains in technology and health care, respectable gains in consumer discretionary and financials — and still crappy revenues from energy, but the sector's poised to improve (with a notable improvement in big oil coming).
Sounds like the end of the earnings recession to me!