The headline: Alcoa beat its third-quarter earnings estimates, defying a crowd of bearish naysayers who had been muttering the aluminum giant was poised to report a loss (even after removing one-time items from its results). Alcoa formally kicked off the earnings season for S&P 500 companies with its announcement after the bell yesterday.
Instead, Alcoa posted a profit from continuing operations of $32 million, or 3 cents a share. Admittedly, that’s small potatoes compared to the 15 cents a share it earned last year, but it’s significantly better than the penny a share analysts had been expecting.
So much for what we know. Now, attention turns to what is still unknown – how the 450-plus members of the S&P 500 that have yet to report their quarterly results fared in the three-month period just ended. The outlook is even bleaker than usual, with analysts predicting the first downturn in corporate profits seen since 2009 and pointing to the early-reporting companies, such as Monsanto, as evidence of that. (The latter just reported fiscal fourth-quarter results that fell short of expectations, amidst weaker than usual sales of seeds.)
Certainly, the earnings outlook is weaker than it was at the beginning of the year, while the S&P 500 is up about 15 percent so far this year. True, the two can continue to diverge, with earnings deteriorating further and the index rallying; all that will happen is the average price/earnings ratio rises. That measure of value is already trading below its long-term average, so that wouldn’t be the end of the world, but in a market that is still nervous or jittery, any kind of earnings disappointment could change sentiment in a heartbeat.
For now, at least, the risk is on the downside, and only as it becomes clear over the next few weeks that once again analysts have been overly bearish in their earnings forecasts, will that shadow slowly dissipate.
A bigger question is whether this quarter’s contraction in earnings will mark a trough of the current earnings cycle. “The strong performances of the S&P 500 and its sectors since June, in which the “500” gained more than 11% in price, led by the cyclical sectors at the expense of the defensive ones, may be a preamble to the coming turn in the earnings tide,” suggested Sam Stovall, chief equity strategist at S&P Capital IQ, in a note to clients sent out on Monday morning. That means this is the time to seize hold of any signs of weakness in stocks in the most cyclical energy, technology, industrial and consumer discretionary sectors. That, Stovall says, is where “the greatest forward earnings and total return advances will likely be recorded.”
While the mood among those analyzing earnings season is still definitely bearish, there is a small but growing chorus of contrarians, arguing in favor of what is thought of as “trough theory.” There are also those who suggest that the current pessimistic outlook is altogether unfounded, and who point to the fact that ahead of each new crop of earnings, analysts have prophesized doom just as enthusiastically -- only for two-thirds or more of the companies they follow to handily beat estimates.
As Kevin Pleines of Birinyi Associates points out in a handy little timeline, LPL warned about this in the spring of 2010; JP Morgan and Morgan Stanley in the early months of 2011; firms like Citigroup, UBS, RBC and others have all prognosticated doom and gloom at various points in the last few years, only to be proven wrong. “The overall negative view of upcoming earnings has not been a convincing reason to exit the market over the past two years,” Pleines argues in a note to clients published yesterday entitled “Earnings Pessimism…Nothing New.”
The pessimism isn’t new but, as we have pointed out, earnings growth has been weaker. So far, that hasn’t stopped the market from gaining ground, although it has weighed on specific stocks or sectors. Considering the decline in revenues and in the rate of profits growth, set against the backdrop of a global economy that may be growing even more slowly than we already feared (as the IMF warned us only this week), investors may be forgiven for failing to take many more leaps of faith. This may, indeed, mark the trough in the earnings cycle, but anyone who chooses to wait for some kind of evidence may be wise.
I’d suggest listening not to what companies report for their third-quarter results, but what they say about their outlook for the fourth quarter and into 2013. If they sound wary or cautious – well, that’s normal pessimism. But if they sound alarmed, as if they are trying to prepare us all for a prolonged period of poor revenues and earnings, that’s a different matter.
Dig into the transcripts of the conference calls that company CEOs routinely have with the analysts who cover them, and look for clues in the ways the CEOs and CFOs respond to forward-looking questions. Read between the lines. And if you think they sound more upbeat than the words they are choosing might indicate, well maybe it is time to hop back into contrarian stocks. If not, you may still want to hang on in some more defensive stocks.
As Pleines admits, if this quarter does mark a turning point, those groups will benefit too, just not as dramatically. It’s called hedging your bets – a great idea in periods of uncertainty and poor visibility.