The stock market has been rising sharply in recent weeks, sending both the Dow Jones Industrials (^DJI 0.67%) and the S&P 500 (^GSPC 0.87%) to record heights. For the most part, favorable economic data have been the primary culprit for recent gains. But next week, the Dow's earnings season kicks off when Nike issues its report, to be followed by a flood of releases in following weeks. With that in mind, here are three things that investors in the Dow Jones Industrials and the S&P 500 should pay attention to as earnings season approaches.
1. Big players can skew results for an entire industry
Often, you'll see sector-wide pronouncements about earnings growth for a particular industry. Before you assume that those conclusions apply to every company within that industry, look at the methodology used to establish sector growth rates.
For instance, as a recent FactSet Research report showed, analysts expect the telecommunications sector to be the best-performing industry in the S&P 500, with earnings growth of almost 23%. But all of that growth is attributable to Dow telecom giant Verizon Communications (VZ -4.67%). Take out Verizon's influence, and telecom earnings acually shrink by almost 7%. Similarly, financial stocks are expected to bounce back sharply in the second half of 2014 compared to slight declines in the first half. But JPMorgan Chase (JPM 1.94%) is the outlier in this group, with second-half earnings per share seen more than doubling from the year-ago figure and accounting for about 40% of the growth rate for financials broadly.
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2. Don't expect lowballed earnings reports this quarter
Traditionally, stock analysts tend to reduce their growth estimates in the months before earnings season starts, and then the actual results turn out to be better than those pessimistic projections. This time around, though, analysts seem to have stopped trying to use that trick, as downward revisions to earnings estimates have been minimal.
Specifically, since the end of March, the estimated overall earnings growth rate has slid from 6.8% to 5.2%. That's the smallest markdown in three years, and means that companies will have more trouble beating expectations than they have in the past. That doesn't mean growth will evaporate, but it does suggest that the positive reaction from growth could be more muted than usual.
3. Prepare for a topsy-turvy season
Not all industries are equally healthy, and that means you could see some whipsawing in investor sentiment, especially within the Dow Jones Industrials. After Nike, the Dow's banking stocks are typically the next to report, and with expectations for financials to suffer another year-over-year quarterly drop in earnings -- the only sector to do so -- Dow investors could start the season off on a negative note. That bad news could send the Dow stumbling temporarily, until better-performing sectors report and provide another perspective on earnings season.
Earnings season is a valuable way to gauge the success of the companies in your portfolio. For now, investors appear optimistic about the prospects for a solid second-quarter Dow earnings season -- albeit with inevitable bumps in the road.
