An upcoming earnings season often moves the stock market as companies receive their quarterly report card (a worthy metaphor given the back to school timing). The grades will start being handed out towards the middle of October, and then continue for six more weeks. Some Earnings seasons are more relevant than others, and this one should hold the market’s attention as investors look to see if the recent success from prior quarters can be repeated. The stakes have been raised because stocks price earnings ratios are high which means investors are looking for continued growth.
At stake is the market direction for the remainder of the year. While there will be macro events that will also move the markets, an upcoming earnings season usually has the most impact. As we approach the upcoming earnings season (somewhat warily), there are four factors that we are keeping a watchful eye on due to their ability to forecast the directions of earnings.
1. Estimate Changes
Estimate Changes in advance of the start of earnings season. Analysts hate to be surprised, and they hate to miss on the high side even more. In a perfect world, they analyze a company, and perfectly understand the trend of the company, but predict the earnings but miss a penny low. The analysts want to show their audience that they have a great feel for the company that they are analyzing.
Companies like this, too. This makes the company look like they are managing their business predictably. They are communicating well with the Wall Street analysts, and they have a handle on their overall business.
This leads to a delicate, slightly awkward dance (think of a middle school dance) where companies provide the analysts with some direction of where their earnings may end up. This can take the form of official Corporate Guidance where the company issues a press release and speak at a conference or, more often, whispers that emanate from corporate offices. Analysts take this guidance and adjust their estimates for the quarter.
In general, these estimates show a slight decline leading up to an upcoming earnings season. Companies and analysts are setting the stage for upcoming earnings to come in slightly ahead of estimates. It is not dissimilar to a student (in this case the company) setting his parents (played by the analysts) expectations for a B grade by saying they probably earned a B- on the test.
So what has been happening leading up to this quarter? Factset is reporting that estimates have declined by 1.1% in the three months prior to the quarter. Normally, estimates will decrease by over 3%. While the estimates have been decreasing, they are doing so at a slower pace. This will be the fourth quarter in a row where this is true, and the prior 3 quarters have been blockbuster earnings seasons. So this phenomenon bodes well for the upcoming earnings.
2. Price Impacts
Price Impacts of this upcoming earnings season have been very strange, and this is the second factor to watch early on in the earnings reports. When a company reports earnings, the markets will move based on the new information contained in the report. If a stock’s price goes up after a positive earnings surprise, this is a called a positive price impact. Normally, when a company surprises, the price goes up. Prior to last quarter,the prior two quarters were bizarre. The price impacts for positive earnings surprises had actually been negative during the prior two quarters.
I wrote about this issue back in April. Fortunately, the market reverted to normal last quarter, and resumed rewarding companies that reported positive earnings. If the companies that report early get rewarded that will set a very positive tone for the rest of this upcoming earnings season.
3. Earnings Growth
Earnings Growth: Companies have reported 20+% earnings growth (year over year) for several quarters now. This outstanding growth has helped put a foundation around the market, and allowed stock prices to climb.
As we entered the year, analysts were concerned about the valuations of companies, and whether growth prospects could justify these prices. As the earnings continue to climb, those fears have largely been allayed.
If companies can actually achieve these forecasts, the market has more upwards trajectory left in it.
4. Which Sectors are driving the Growth in Upcoming Earnings?
Earnings season always features winners and losers. Not only do investors look at the actual growth levels, they will also examine them in regards to expectations, or in other words, what the analysts estimated.
Over the last two quarters, almost every sector outperformed expectations and produced positive earnings growth, and this quarter could stack up the same way. Remember, this quarter has strong expectations at an aggregate level.
Energy is continuing to rebound from a disastrous year ago comparison, while Financials and Materials continue their very fast pace. Keep an eye on Real Estate. As interest rates rise, there will be negative impacts on the Real Estate sector. Not even a solid economy can override these impacts. This is beginning to show up in a much lower growth forecast. With the Fed poised to continue interest rate increases, the real estate sector probably has some tough sledding over the next few quarters.
The Tech Sector which has been on fire over the past four quarters is beginning to cool down, although 15% growth is nothing to sneeze at. As trade wars and tariffs heated up last quarter, it will be interesting to watch if these headwinds show up in their earnings number.
So keep a watch on the sectors performance to see if these themes are borne out by the numbers.
A Summary of What to Expect this Upcoming Earning Season:
It seems that I say, “this earnings season is going to be the most important”, but once again, we enter the season with that being the case. Valuations are still high, and the market is anxiously looking for confirmation that earnings growth will continue and validate these valuations.
Underneath the top level numbers, sectors are beginning to rotate. The winners should begin to show themselves this upcoming earnings quarter as interest rates bite sectors that are sensitive to higher rates. By the end of the quarter, markets will have adjusted based on the results.
Keep an eye on the price impact. If stocks are rewarded for positive earnings surprise, then the market has a solid foundation. Finally, watch for corporate guidance coming after the earnings report. There are still very strong expectations with regards to future quarters, so it is important that these are not dampened by pessimistic corporate pronouncements.
So now, you can grab your popcorn and watch the grades roll in. Parental expectations have been set for an A Student performance so let’s hope all the companies have been doing their homework!