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aluminium giant Alcoa kicks off the unofficial start to the Q3 earnings reporting season in the United States on Tuesday afternoon after the closing bell.Q3 earnings will be notable for one important reason: the aggregate profit growth of publicly-traded corporations is expected to turn negative for the first time since the financial crisis of 2008.
Morgan Stanley’s chief U.S. equity strategist Adam Parker says many clients are asking “if there can be an earnings recession without an economic recession.”
BofA Merrill Lynch equity strategist Savita Subramanian addressed the question similarly, writing, “While this is a rare occurrence outside of recessions, it has happened, most recently during the Asian and Russian financial crises of 1997-98.”
And Sean Darby, global head of equity strategy at Jefferies, recently compared the stock market’s current rally into third-quarter earnings with the rally of 2006-2008 that directly preceded the bursting of the housing bubble.
In a note, Darby writes:
Ironically, there are some subtle similarities of the recent equity rise to the 2006-08 stock rally. At that time, the global economy was booming, but conditions within the US housing market were deteriorating with physical prices falling and spreads on subprime widening. It took nearly a year for the infection from the housing market to spread to the real economy through a widening of interbank and corporate bond spreads.
Today, the housing market is improving, but the global economy is slowing. However, credit spreads have tightened as the Federal Reserve’s QE policies have forced institutions and investors to acquire yield. Hence, a turning point for equity investors under the current monetary conditions is likely to occur when revisions to corporate ratings swings sharply negative.
Meanwhile, equity analysts continue to revise more earnings outlooks downward than they are revising upward at the moment. In other words, the tone on Wall Street is still quite bearish.
Matt King, Citi’s global head of credit strategy, writes in a recent note to clients that he expects the tone to get more bearish from here as the ratio of downward to upward revisions rises.
However, King doesn’t think that any of this necessarily means an end to the market rally:
Might continued downward revisions to earnings be on the verge of producing a similar correction in markets? Possibly, but not necessarily. While we are nervous that markets have seemingly been disregarding signs of a GDP and earnings slowdown in China, Europe and the US, they have been doing so for five months now. The obvious culprit is the central bank liquidity injection. But if anything, this seems set to intensify.
On the other hand, Deutsche Bank’s chief US equity strategist, David Bianco, thinks markets are getting ahead of themselves. He writes in his latest note to clients that while investors “expect” Q3 earnings to be disappointing, “hope” about possible EPS surprises is creeping back into the conversation.
Bianco writes, “We think whispers of hope are pushing the S&P 500 toward 1475 and we fear that the risk of disappointment might be greater than the usual expectation indicators suggest.”
With weak expectations providing the backdrop for imminent Q3 earnings reporting, here are a few things to keep an eye on.
Deutsche Bank macro strategist Jim Reid writes that this earnings season, “guidance will probably be as important as Q3 numbers for which weakness has already been priced in.”
Citi’s Jason Shoup agrees, writing, “Where we do see danger lurking is with guidance and tone.” On top of that, Shoup says that analysts’ expecations for both Q4 2012 and all of 2013 are still “far too optimistic,” which could be a problem going forward.
Shoup highlights this chart, which shows how analysts still haven’t adjusted their earnings estimates for a scenario that includes a drop in EPS growth:
However, Shoup also writes that “while Q3 may end up being the weakest quarter this year, we believe it’s unlikely to bring a halt to the rally. In our view, it’s far more likely that fourth quarter earnings season captures that honour, if the macro headwinds don’t blow the market off course beforehand.”
There are two things to watch that might be more important than the headline earnings numbers themselves, which everyone clearly expects to be weak.
BMO’s chief investment strategist, Brian Belski, says one “recent and important trend has gone largely unnoticed as most investors have been acutely focused on slowing EPS growth.”
That trend: earnings quality.
Belski writes in his latest note:
Even if earnings growth winds up being weak as expected, a recent and important trend has gone largely unnoticed as most investors have been acutely focused on slowing EPS growth rates: the quality of S&P 500 earnings has improved lately (Chart 4). Stated differently, cash earnings represent a larger portion of reported EPS. According to our work, this has typically had an important and positive effect on valuation. Based on our analysis, stronger earnings quality leads to higher P/E multiples.
For instance, we examined quarterly data since 1990 and found that the S&P 500 forward P/E multiple expanded by an average of 0.4x in quarters when the earnings quality ratio improved. Conversely, P/E multiples contracted by an average of 0.2x quarters when the earnings quality ratio deteriorated. However, P/E multiples have by and large been contracting despite improving earnings quality over the past several quarters. Thus, we believe P/E multiples can expand by even more than average in the upcoming quarters as earnings quality continues to improve (as we expect).
And BofA’s Savita Subramanian says to keep an eye on sales growth (the top line) while everyone is obsessing over earnings (the bottom line):
With cost structures already lean, sales growth is increasingly important for companies’ ability to grow earnings. Sales were flat last quarter, and this quarter analysts expect -2% YoY growth, or -1% ex. Financials. We expect the combination of lower commodity costs vs. a year ago, negative operating leverage and a deceleration in buybacks has caused Non-Financials EPS growth to decline more than sales growth. Amid this top-line scarcity, we would look for companies which can beat on sales, as these were rewarded most last quarter. And as expectations for companies with high foreign sales remain low, we would also expect this group to be disproportionally rewarded for positive surprises as was the case last quarter.
Alcoa reports earnings tomorrow afternoon after the bell. We will have LIVE coverage here on Money Game >