The Independent Market Observer

Earnings and Expectations

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Apr 8, 2015 1:44:12 PM

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earningsIn the interviews I’ve given recently with various financial media, the questions have centered on earnings season—the time every quarter when companies report how much money they made, in revenue, and kept, in earnings, in the last quarter.

This matters, certainly for the stock market, which is priced off of those earnings, but also for the economy as a whole. If the economy is doing well, companies should be doing well.

That point is what’s prompting the questions, because expectations—what analysts expect companies to make—have come down dramatically over the past three months. Rather than companies in aggregate making more money, they’re actually expected to make less, which is very unusual and historically worrying.

Are lower expectations a red flag?

In a word, no. The projected earnings decline is the worst since 2009, which gives us a useful basis for comparison. In 2009, earnings estimates were coming down because the economy was cratering. The financial crisis hit asset values, jobs, spending, everything. It was very reasonable to expect earnings to decline.

This time around, however, the economy is actually growing, although at a slower pace than last year. Housing prices are rising, wages are increasing, and employment is growing at the fastest rate since 1998, even given the recent weak jobs number. Historically, earnings declines have been associated with recessions. This time, we’re not seeing that.

Instead, the major factor in earnings declines has been the drop in the price of oil, which FactSet estimates accounts for fully half of the decline. Including energy, earnings are expected to decline 4.6 percent, but excluding energy, they’re expected to increase by 3.4 percent. The problem this time is the decline in oil prices, not weakness in the U.S. economy. In fact, lower oil prices should actually improve U.S. economic growth over time—one more reason that lower earnings expectations aren’t the red flag for the real economy this time that they have been in the past.

What about the stock market itself?

Even if the decline in estimated earnings doesn’t signal a recession, could it mean a market correction?

It could, of course, but I suspect not. When analysts prepare their estimates, companies often weigh in with guidance as to what they expect, which the analysts take into account. Companies have an incentive to guide lower, so as to beat those expectations. With slowing economic indicators, and the general pessimism around earnings caused by the decline in oil prices, it’s quite possible—and I would argue, probable—that they’ve taken the opportunity to set up some fairly easy hurdles.

Consider that, although 84 percent of companies that have provided guidance have been negative:

  • In aggregate, only 6 out of 10 sectors , or 60 percent, are expecting earnings declines, which is a pretty substantial discrepancy.
  • It’s early days still, but 80 percent of the (very small) number of companies reporting so far have beaten their estimates handily. (All numbers are from FactSet.)

The way the market reacts will have much more to do with how the actual results compare with expectations than anything else. The current drop in earnings expectations is the worst since 2009, and whatever else may be going on, we’re not in another great financial crisis. I expect to see the actual earnings numbers come out better than expectations, which could very possibly lead to a positive surprise from the markets.

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