Earnings Season Is Approaching. Are You Ready?

September 28, 2016

Earnings Season Is Approaching. Are You Ready?

  • Earnings will decline for the sixth consecutive quarter.
  • We question the 2017 forecasted earnings growth based purely on higher oil prices.
  • We’ll take a look at what can be done to limit your risks and increase returns.

Introduction

What we know is that for the last 5 quarters, the S&P 500 has had declining earnings. The situation doesn’t seem to change course for the next quarter, but most analysts expect earnings growth to come in 2017 as a result of a rebound in energy prices.

As our readers know, this rebound should have already happened six months ago according to the same analysts’ expectations. In this article we’ll tell their story, but we’ll also analyze what else is out there that can influence future earnings.

Current Earnings Situation 

As already mentioned, S&P 500 earnings have been declining for 5 consecutive quarters.

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Figure 1: S&P 500 earnings. Source: Multiple.

The energy sector, with a year over year Q2 2016 earnings decline of 84.1%, is the main reason behind the earnings drop but it isn’t the only one. Real estate has seen earnings decline by 12.9% while materials, financials and industrials have also seen earnings decline. Consumer discretionary, telecom services, healthcare and utilities are the winners.

figure-2-q2-2016-growth
Figure 2: S&P 500 earnings growth per sector. Source: FACTSET.

Forecasted Earnings

If the energy sector rebounds we will see earnings growth in the future, but given that the price of oil is much lower than it was in Q3 of 2015, we can be sure more earnings declines are ahead.

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Figure 3: Oil prices in the last 5 years and Q3 2015 and Q3 2016. Source: Bloomberg.

The estimated earnings decline for Q3 2016 is -2.3%, but analysts estimate oil prices to increase and push S&P 500 earnings higher in 2017.

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Figure 4: Analysts’ oil price forecast for 2017 and S&P 500 energy earnings. Source: FACTSET.

With analysts forecasting higher oil prices, it makes you wonder if they are placing leveraged bets on rising oil in 2017. Who knows, maybe they are “betting the farm” and will retire rich leaving us no more analysts. Don’t worry, this analyst is not betting on rising oil prices so I’ll still be here writing independent and unbiased investment research through Investiv Daily, even if all other analysts are sipping margaritas on a beach somewhere.

All jokes aside, forecasting oil prices is impossible to do correctly on a consistent basis. If it were possible, the most famous investor wouldn’t be Buffett, but instead would be some oil trader. Oil prices will certainly be volatile, but the high prices from the beginning of this decade have influenced a high level of investment which makes it very easy to increase output as soon as oil prices increase.

As car consumption lowers and electric vehicles increase in numbers, the long term picture for oil isn’t positive. You can read our article on coal to see what could happen to oil. In any case, don’t bet everything on oil just because what goes down should go up, that wasn’t the case with coal and the oil industry might witness a similar secular shift.

In addition to the oil issue, the FED could finally increase interest rates in December and all companies could see higher borrowing costs. This would weigh on all sectors and push earnings down. The guidance for Q3 2016 is negative, so you know what to expect in the next few weeks.

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Figure 5: Q3 2016 guidance – percentage per sector. Source: FACTSET.

Apart from the uncertain commodities outlook, another risk to the above earnings outlook is a U.S. recession. According to the Wall Street Journal and the 60 economists it interviews regularly, there is a 20% chance of a recession occurring in the next 12 months.

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Figure 6: Probabilities of a recession. Source: Wall Street Journal.

As a recession is always around the corner, it’s not smart to base your investment decisions on the fact that oil is bound to go up and thus increase S&P 500 earnings.

What Can Happen

In the best case scenario, the economy continues to grow and oil prices increase which pushes earnings higher. The effect this could have on stock prices is minimal as analysts expect this and therefore it is already priced into the current stock valuations.

In the realistic scenario, oil prices continue to be volatile, and the FED increases interest rates just slightly since the low-rate stimulus is good for the economy. In this case, the S&P 500 continues on the same track as it has been on for the last two years, which means going almost nowhere.

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Figure 7: S&P 500 last two years. Source: Nasdaq.

In the worst case scenario, a recession hits the U.S. and earnings sharply decrease which pushes the S&P 500 into bear market territory and we have a new bubble name, the FED bubble.

With the upside being limited due to high valuations and very positive expectations, it might be wise to take the time and look at what you can afford to lose in exchange for the lowest historical market yields.

What To Do

Earnings are essential to investing as in the long term they are perfectly correlated with investment returns. Higher earnings enable higher dividends which in the end increase stock prices. As we have seen above, not all sectors have earnings move in the same way. Therefore, being overweight in the sectors that have positive future developments can help you outperform the market in the long term.

If a recession comes, all sectors will see a decline in earnings, so going deeper into specific stocks will give you the edge. In the healthcare sector, the discretionary part will certainly suffer, but unavoidable healthcare services and drugs will not be affected by a possible downturn. As things are now, you might even find those companies on the cheap as their growth is expected to be smaller when compared with the discretionary segment.

Another idea is to look at how diversified your portfolio is internationally. As developed countries are slow growers and emerging markets are booming, it might be a good idea to be more internationally oriented which does not mean you have to leave the S&P 500 as 31% of its revenues are international. For more on international diversification, check out our article from last month here and look to specific sectors for exposure.

figure-8-exposure-by-sectors
Figure 8: International exposure by sector. Source: FACTSET.

Stay tuned to Investiv Daily for the latest on structural trends, fundamentals and short term catalysts.

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