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Earnings season starts next week and, once again, investors will be looking for signs of whether the fundamental strength of individual companies warrants the large advances in stock prices that we've seen over the past four years. With the stock market having given up ground in June, the stakes are higher than ever, as doubt has started to creep into investor sentiment. But bulls should take heart in the fact that estimates of earnings growth for the quarter are actually stronger than they've been in previous quarters.
The expectations game
At this point, before companies start making their quarterly reports, looking ahead to earnings season is all about two things: overall market sentiment, and any warnings that individual companies have issued. We've all seen firsthand how sentiment has shifted in a more negative direction over the past month, as declines in the Dow Jones Industrials (DJINDICES: ^DJI ) , as well as broader stock market benchmarks, didn't immediately give way to buy-on-the-dip rebounds. And, because company warnings tend to be negative, earnings projections often reach their low point right before the season starts.
Yet, even with that negative bias, Thomson Reuters reports that overall second-quarter earnings estimates for the S&P 500 (SNPINDEX: ^GSPC ) suggest year-over-year growth rates of about 3%. That doesn't sound like stellar growth, but it's better than the near-zero growth projections that we've seen in previous quarters.
Moreover, at least recently, earnings estimates have tended to reverse course and climb once actual data becomes available. During the first quarter, S&P earnings growth of more than 5% came in almost four percentage points higher than estimates as of the beginning of April, before that particular earnings season began. Add in that same positive movement and, by the time companies finish reporting over the next few months, earnings could jump by 7%.
Where the growth is -- and isn't
Recently, earnings growth has centered on two primary industries: telecom stocks and financials. Again using Thomson Reuters figures, those areas show prospects of about 18% growth for the second quarter. For financials, rising interest rates actually have the potential to help, especially on the insurance side of the business where insurers rely on income from investment portfolios to help defray claim costs. Yet, even for banks, rising net interest spreads have investors excited, with Bank of America (NYSE: BAC ) weighing in at more than 30%. Because earnings at B of A, and some other banks, have been at depressed levels for some time, overall industry gains might be somewhat misleading, but they still promise to have a substantial impact on S&P earnings overall.
Meanwhile, for telecoms, strong demand for smartphones, and steps to try to contain costs, are helping earnings prospects. Both AT&T and Verizon (NYSE: VZ ) have taken steps to align the upgrade cycle with the 24-month contractual commitments that smartphone-buyers take on, alleviating part of the subsidy penalties that the companies suffer in offering upfront discounts when customers get new phones. In the long run, both companies might need to look abroad for further gains, but for now, they're making the most of what they have.
By contrast, utilities and materials stocks are poised to show declines. For materials, that comes as no surprise, given the slowdown in demand for commodities, and the corresponding plunge in commodities prices for many major markets, especially gold and silver. Meanwhile, utilities have had to deal with rising natural-gas prices that have increased costs just as they've made big investments in shifting to gas-fired power plants. Moreover, the prospects for rising interest rates are forcing utilities to consider increased financing costs over the long run, and the latest climate-change policies from the Obama administration are raising plenty of question marks among utility investors as they consider how much money it will cost to comply with whatever new regulations eventually come from the policy. Even Exelon (NYSE: EXC ) , whose nuclear plants arguably protect it somewhat from criticism over fossil-fuel power production, has traded near multiyear lows, as investors question its ability to keep earnings growing.
Keep your eyes open
As earnings season begins next week, you'll want to watch closely to see how early reports compare with expectations. Anything other than the usual share of positive surprises could make investors even more nervous than they are now, but strong reports could push the Dow up on a new leg higher.