Earnings posed a legitimate headline risk in the second quarter: total earnings for S&P 500 companies were down -2.1% from the same period last year on -3.4% lower revenues. Yikes.
And, that’s coming off a weak first quarter when earnings basically flat-lined nudging only +0.8% higher. Current expectations are that earnings will be negative in the third quarter as well, with total earnings for the S&P 500 index expected to be down -5.5% from the same period last year on -4.4% lower revenues.
With aggregate earnings flailing, investors may wonder what’s left to be optimistic about – China’s woes have created volatility with global markets, cratering commodities prices are hurting energy exporters (particularly Emerging Markets) and Europe is still growing at less than 1%. Sure, U.S. GDP is still positive, but in the absence of positive earnings doesn’t that mean stock prices are at risk?
With Earnings, The Devil’s in the Details
And by details, I really mean: strip away the Energy sector. Indeed, the Energy sector was the driving force behind the aggregate decline for earnings on the quarter. If you take away Energy, total earnings for the S&P 500 would have been up +5.2% in Q2 on +1.3% revenues. And, on a forward looking basis, I think the same will apply to Q3 – take away Energy, and total earnings for the index may end up +1.7% on +0.7% higher revenues.
To be sure, this is not to say that the Energy sector is the only reason aggregate earnings are down. It’s just that Energy has been battered so badly that it’s playing a disproportionately negative role. Earnings for the sector are down nearly 70% year-over-year. What we’re seeing is an Energy sector recession, not an aggregate earnings recession.
To be fair, for Q3, half of the 16 Zacks sectors are expected to have lower earnings relative to Q3 2014. Industrial Products are expected to dip -24.5%, Conglomerates -15%, Basic Materials -13.3%, and Consumer Discretionary -12.5%.
On the positive side, Financials are expected to have another good quarter with earnings expected to rise
+8.8% after posting a +7.2% gain in Q2. Other sectors with positive earnings growth in Q3 include Transportation (+16.5%), Autos (+21.3%), Construction (+8.7%), and Medical (+8.1%).
The numbers set the narrative for our current bull market with an economy that is maturing and driving growth in some areas and contraction in others. At Zacks Investment Management, we constantly evaluate where we believe sectors and industries are headed. Then, we base our distinct investment decisions on those insights to overweight or underweight as appropriate. I won’t get specific here on what we’re favoring now versus not, but you’re always welcome to contact us to find out.
At the End of the Day, It’s All About Expectations Versus Reality
With company earnings, what really matters is whether or not, in aggregate, they do better than expected. Dour expectations often mean two things: 1) the market is pricing-in those dour expectations, so there’s a good chance for an upside surprise; and, 2) pessimism is still pervasive in the marketplace, which means there’s still a wall of worry for stocks to climb.
The chart below shows current consensus earnings growth expectations for the coming quarters. Again, what really matters about this chart is whether companies can actually deliver better than expected earnings, and I think they can.
Bottom Line for Investors
Energy, energy, energy. If you focus on the negative aggregate numbers without realizing Energy is driving overall earnings to the downside, you might mistakenly assume the trend for S&P 500 companies is recessionary. It’s not. There are patches of weakness, but that’s expected in a maturing bull market. In your portfolio, the key is to underweight the weak areas and overweight the ones with brighter outlooks.
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