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Here's What to Focus on for Earnings Season

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Thursday, July 16, 2015
Money and Markets
Here's What to Focus on for Earnings Season
by Mike Burnick

Dear ,

Mike Burnick

Investors have been distracted recently by the never ending Greek debt drama, and the 35% crash in mainland China's stock market. So it's easy to forget that we're once again in the midst of earnings-reporting season.

But the sales and profit results from corporate America over the next several weeks will have a much greater impact on the direction for U.S. stocks.

So let's take a closer look at what to expect this earnings season.

Not-so-great expectations

First the bad news: S&P 500 profits for the just ended second-quarter of 2015 are expected to decline 4.5% year over year, according to Merrill Lynch estimates. There are two main culprits:

#1: A stronger U.S. dollar, which cuts into overseas sales and profits, and ...

#2: Lower oil prices, which have decimated the earnings of energy-sector stocks.

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If estimates are proven correct, it would be the first outright earnings decline since the third quarter of 2012. But keep in mind it's a time-honored tradition on Wall Street for public companies to under-promise and over-deliver.

Click image for larger view

Management teams are often conservative with the profit guidance they give analysts in order to set a low hurdle rate for earnings that they can easily step over, delivering a positive profit surprise. Over the past four years, 72% of companies in the S&P 500 have reported actual earnings above expectations.

And over the last three years, S&P 500 companies delivered positive earnings surprises of 3.5% above expectations, on average. Still, with current estimates calling for -4.5% as reporting season begins, a 3.5% earnings "beat rate" may not be enough.

More troubling still is the lack of top-line sales growth from America's blue-chip companies. Second quarter revenues for S&P 500 stocks are forecast to decline 4.2% year over year. Without strong organic sales growth, companies must rely on cost-cutting measures, or worse, other forms of "financial engineering" to keep bottom line profits growing. And this is simply not sustainable long term.

Click image for larger view

In fact, many analysts are worried that corporate profit margins may have peaked already, which is often a precursor to a meaningful correction in stocks, perhaps even a bear market and recession scenario. In the chart above courtesy of JP Morgan, you can see that operating profit margins have already pulled back from recent highs.

More than meets the eye

The good news is there's more than meets the eye to S&P 500 profitability and the overall picture isn't quite as bad as it seems.

First, deeply negative earnings comparisons for energy sector stocks are masking the decline in overall S&P 500 sales and earnings, making results look far worse. Energy sector profits are expected to plunge 63% year over year, with top-line sales down 36.7%! This is all due to the large drop in crude oil prices today compared to this time last year.

Excluding the energy sector, S&P 500 earnings are forecast to grow nearly 2% in the second quarter, with sales up 1.5%, which still isn't much. But add in the usual earnings "beat rate" of 3.5% and stock market profits (ex energy stocks) could climb a more respectable 4% to 5%.

Second, it has become a stock-pickers market again with certain sectors and specific stocks performing much better than the averages. This is very true in terms of profit estimates as well.

For instance, Health Care companies are expected to post earnings growth of 8.2% year over year, according to estimates compiled by FactSet. Profits for the financial and consumer discretionary sectors are both poised to grow 4.5%. Also, analysts have been raising their estimates for health care stocks in recent months, plus the sector delivered a 7% positive earnings surprise last quarter, a good sign for investors in health-care stocks.

Also, according to research by Merrill Lynch, higher quality companies are more likely to beat both sales and earnings growth forecasts. We have found the same correlation in our own research at Weiss, which is why it makes sense to favor highly rated stocks according to our Weiss Stock Ratings model.

Bottom line: Earnings reporting season is bound to be full of surprises in the weeks ahead, and it will be a close call whether or not we see much growth in profits overall. That's why you should be ultra-selective with your investments right now, and emphasize the highest quality stocks for an extra margin of safety this earnings season.

Good investing,

Mike Burnick

The investment strategy and opinions expressed in this article are those of the author's and do not necessarily reflect those of any other editor at Weiss Research or the company as a whole.

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