Earnings Season Preview: Prepare to Be Disappointed

Earnings Season Preview: Prepare to Be Disappointed

Getty Images/iStockphoto

A measly 5.7 percent. That’s all the earnings growth we’re likely to see for the just-ended second quarter of 2012, according to calculations by Thomson Reuters analyst Greg Harrison, based on analysts’ predictions for companies in the S&P 500 index. After nearly three years of double-digit gains in earnings, 2012 is shaping up as a year of not only economic anxiety and market volatility, but also underwhelming profits.

Even worse, that expected 5.7 percent increase probably overstates the real gains we’ll see as the second-quarter earnings season gets underway.

Alcoa (AA) kicked things off Monday by reporting a net loss of $2 million. Excluding special items, its operating profit came in at $61 million, or 6 cents a share – better than analysts had expected. But once the reports start rolling in, the reality is that a single company – Bank of America (BAC) – is going to make the numbers appear much better than they really are. That’s because last year’s second-quarter – the period against which the percentage gain is calculated – included a massive charge against earnings by Bank of America following a settlement of a lawsuit related to mortgage-backed securities. That is going to make the bank’s earnings gain this quarter look astonishingly good, when really that increase will simply reflect the lack of extraordinary charges.

Indeed, Harrison calculates that removing Bank of America from the equation brings estimated earnings growth to a measly 0.6 percent. In other words, analysts are predicting that as the numbers are made public over the next five weeks or so, we’ll see that profits barely grew at all.

With the steady drip of underwhelming news about the economy offering one headwind for stocks, and developments in Europe’s sovereign debt crisis a reliable source of turmoil and anxiety, the lack of earnings growth – if it materializes as expected – is going to knock the final prop from underneath stock prices.

True, stocks right now are trading at remarkably low valuations: The S&P 500 commands a price/earnings multiple of only 12, compared to a ten-year average of 14.3. But investors are nervous – and without a reason to drive up those valuations, in the form of either a strengthening economy or more robust earnings, odds are that they’ll stick stubbornly to the sidelines.

That’s not to say that there won’t be some positive earnings surprises in the coming days – perhaps even some astonishingly large ones. Apple (AAPL) has a habit of downplaying its expected growth and then delivering a big surprise; Netflix’s (NFLX) CEO proclaimed on his Facebook page last week that the company had delivered a billion hours of streaming content to its subscribers last month, confirming newfound optimism on the part of analysts that it may generate a profit for the quarter rather than a loss.

And companies that have announced their results for the quarter in what has been dubbed the “preseason,” have reported earnings growth of about 8 percent, Harrison calculates. Of the 25 companies that did so, 64 percent announced positive surprises, compared to the long-term average of 62 percent.

That still isn’t as good as the recent beat rate of 68 percent for preseason announcements – and a “positive” earnings surprise can still turn out to be underwhelming, given the increased tendency of both analysts and companies to talk down expectations. After all, the more the more successfully they jawbone, the more likely that the figures they actually report will turn out to be a positive rather than a negative surprise, and have the potential to translate into a boost for their stock price.

It seems likely as if it’s all going to come down to a question of who investors believe – and whether they are willing to react as predictably to the smoke and mirrors game of expectations versus reality that tends to characterize earnings season.

There are plenty of problem areas for companies trying to boost their earnings, most notably the lack of economic growth and demand. (Retailers reported very meager growth in same-store sales for June, another warning sign that consumers are starting to take a more conservative attitude toward spending.) Almost the only positive note is that energy prices have slumped since their highs of early this year, meaning that companies whose major expenses include gasoline, jet fuel or other kinds of raw materials will benefit from a welcome decline in those costs. On the flip side, it also means that the materials sector of the S&P 500 is likely to see earnings decline by more than 12 percent, according to analysts’ estimates compiled by Thomson Reuters.

Estimated Q2 Profit Growth by Sector

SectorProjected Growth
Consumer Discretionary3.4%
Consumer Staples1.4%
Health Care0.1%
Telecom Services1.0%
S&P 5005.7%

The next few weeks will generate a lot of headlines and a lot of data points. We’ll probably get some more insight into just how large the impact of the London Whale’s trading will be for JPMorgan Chase (JPM) when the bank reports its second-quarter results at the end of this week. (And we should also get a sense of how strong the pressure is for the bank’s CEO, Wall Street wunderkind Jamie Dimon, to follow the lead of Bob Diamond of Barclays and fall on his sword to atone for having either condoned the trading or failed to notice what was going on.)

Those types of company-specific data points will likely be the most helpful to investors. Does it help to know that health-care companies may see earnings remain flat, while energy companies could see their earnings plunge 15.3 percent? Sure – but what matters just as much is identifying the outliers; those companies that are able to do better than expected and better than their peers. And, of course, to identify those who are about to blow up, spectacularly, reporting losses of a magnitude that even the most bearish of analysts couldn’t have imagined.

In a slow-growth environment, when that sluggishness is a feature not only of the broad economy but also of corporate profits, spending more time on company-specific research will prove vital to stock market success.