MARKETS SPECTATOR: Massaging expectations

Investors have dragged down expectations ahead of the third quarter reporting season in the US. But the market, and history, suggests they might have been a little too bearish.

With the US third quarter earnings expectations bar lowered, there’s plenty of evidence to suggest the bears won’t have it all their own way.

Once again, the quarterly US reporting season is upon us, and hence the tired predictions of another dire performance. We kick off in earnest tomorrow evening with Aluminium giant Alcoa set to open proceedings.

Judging by expectations and past earnings periods, it may not be the doom and gloom most people are peddling.

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For the September quarter, the broad-based S&P 500 index rose 5.8 per cent. Interestingly, over the same period expectations for the upcoming earnings season went from across-the-board earnings per share growth of 1.9 per cent to a decline of 3.4 per cent, which represents the weakest quarterly earnings growth since 2009. You can see this trend in the chart above, where the circle indicates the period where third quarter earnings expectations were ratcheted lower.

Normally, one would expect price action among stocks to reflect this downgrade; however the old adage ‘don’t fight the Fed (and ECB)’ seems to have rung true.

The other factors that no doubt influenced this strength were, firstly, corporate balance sheets in America are in very good shape and, secondly, the market typically looks forward, meaning investors are probably already looking forward to the expected rebound in fourth quarter earnings, as can be seen in the above chart.

For those bearish ahead of third quarter earnings, it’s worth noting that 13 of the last 14 quarterly earnings seasons have surprised to the upside and beaten EPS expectations. Analysts and the investment community have a habit of getting too bearish ahead of reporting season.

We’re willing to side with the odds and believe that, once again, Wall Street have become too bearish and got it wrong in terms of EPS growth. However, when it comes to stock prices, the second quarter’s strength has thrown a bit of a spanner in the works. We’re unlikely to see broad-based gains for the S&P 500 but we do see room for upside in stocks that remain cheap on a price to earnings basis.

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