Earnings season begins unofficially Friday. Here's what to look for:
The stock market is holding up because the global economy is improving and earnings are improving. The market turned around in the second quarter of 2016, which is when the earnings recession came to an end, after earnings declined for five straight quarters. The turnaround has been impressive and this is the main reason stocks have moved to new highs:
S&P 500 earnings
Q1: down 6.7 percent
Q2: down 3.1 percent
Q3: up 2.8 percent
Q4: up 5 percent
Q1: up 14 percent
Q2: (est): up 7 percent
Q3: (est) up 8 percent
Those second- and third-quarter numbers will go up — most likely they will be above 10 percent. The market is betting on it.
The market is relying on significant earnings growth from its two largest sectors: technology and financials, and a big boost from its most beaten-up sector, energy.
Q2 earnings: What matters
Technology: up 11.2 percent
Financials: up 7.5 percent
Energy: up 600 percent
Source: Thomson Reuters
Those three sectors account for 83 percent of the earnings gains traders are expecting for the quarter.
"Semiconductors have been on fire, and that's a big boost for tech," David Aurelio from Thomson Reuters told me. "Bank estimates have come down a bit because rates have not moved up as much as expected, but they are still expected to post gains. But the big boost is coming from oil stocks, which hit rock bottom in the first quarter of last year."
The largest risk is in energy. About 40 percent of the growth in earnings is coming from this one group, according to Aurelio, which is a lot, considering energy is only 7 percent of the S&P 500. Earnings for this group are expected to be up 600 percent.
How could that happen? How could anything be up 600 percent? Because the profits of the big oil companies suffered a historic collapse in the first and second quarters of last year. In the second quarter of 2016, all the energy stocks made roughly $1.26 billion in profits (these numbers are adjusted for market capitalization). For the second quarter of 2017, analysts are expecting them to collectively report earnings of $8.18 billion, according to Thomson Reuters.
And this is where things get a bit dicey. Let's start with energy. Oil stock prices and oil are closely correlated. Oil prices dropped about 20 percent in the second quarter. There is a 93 percent correlation between oil prices and S&P 500 energy sector earnings. Analysts were expecting oil prices to be closer to $60 a barrel by this time, not $40-$45. They had been pricing in much higher earnings for the second quarter. At the start of the second quarter in April, analysts were expecting $10.4 billion in profits for the energy group, but since they have been cutting the numbers almost every day, now down to $8.18 billion.
That's a drop of about 25 percent in expected profits! And you can see what this has done to oil stocks: The main oil ETF (XLE) is down 6 percent since April, after dropping more than 10 percent in the first quarter.
And the numbers are still coming down. Thursday morning, Evercore lowered its earnings estimates for big oil companies by 16 percent for the second quarter and 6 percent for the full year.
Yikes! The key is that analysts have already adjusted for this quarter, so it's the commentary on the third quarter that will move the markets. And expectations are still high for the third quarter. If oil remains close to $40, you'll see the numbers come down for that quarter as well.
Here are other risks to earnings in the second half of the year:
- A strong dollar. Technology generated nearly 60 percent of its revenues overseas. Industrials also generate significant profits overseas, so any rally in the dollar — which would make exports more expensive — is a problem. Fortunately, the dollar has been generally weaker in the second quarter (particularly against the euro), though it has been stronger against the British pound and the Mexican peso. Several companies mentioned the effect of a higher dollar as a negative or potential negative in this quarter's earliest round of companies reporting, including Walgreens Boots Alliance, Constellation Brands and McCormick & Co.
- Higher wages. Janet Yellen, in her congressional testimony Thursday, noted again that the labor market was tight and that this might lead to upward pressure on wages. Margins could come under pressure if wages keep rising. FedEx and AutoZone both noted wage pressure in their recent reports. So did Darden Restaurants: "Restaurant labor was unfavorable 10 basis points as continued wage pressures slightly offset productivity gains."
- Capital spending. Cash reserves for corporate America are at an all-time high. Spending on buybacks has been reduced slightly this year and spending on capital expenditures has increased. CEO optimism is on the rise: The Business Roundtable's CEO Economic Outlook index reached its highest level in three years. All of this is good news for further capital spending, which would have a positive impact on industrials and materials.
- Tax cuts. The Trump administration said earlier this week that it was committed to getting tax reform completed sooner rather than later, i.e. this summer.
It's coming at the right time. For earnings, tax cuts are a 2018 event, as no one is raising 2017 estimates on hopes of a tax cut. The problem: Business executives are losing confidence that anything will happen this year. A report from the Tax Council and Ernst & Young indicated that only 26 percent of U.S. business tax executives believe that tax reform will happen this year, down from 48 percent in January.
Will a tax cut really be worth the wait? There is still some premium in the market in expectation of tax cuts for 2018, but how great is not clear. Will it have an impact on earnings? The short answer is yes, depending on the extent of the cut. CFRA Research estimates that 2018 earnings will grow by 12 percent without a tax cut. A cut in the corporate tax rate from 35 percent to 20 percent would improve earnings growth to 20.4 percent, an 8 percentage point improvement. That is significant. A cut to 30 percent would only bring earnings growth to 13.7 percent, a little less than a 2 percentage point improvement.
So the size of the cut matters a lot, and it's likely this may matter more to the market soon.