The stock market has been turbulent in recent months, as investors have focused on a wide range of factors to assess whether the bull market will extend into a seventh year in 2015. Yet even as macroeconomic factors like monetary policy and plunging oil prices have sent stocks moving violently, the value of stocks ultimately depends on how much money companies can earn. Earnings season officially began last night with Alcoa's (NYSE:AA) quarterly numbers, and the stock market responded favorably this morning to the aluminum giant's positive results. As of 12:30 p.m. EST, the Dow Jones Industrials (DJINDICES:^DJI) were up 150 points, with all but five of its 30 component stocks climbing.
Yet the big question investors face is whether the rest of earnings season will go as well as Tuesday's market action indicates. Even though there are many positive factors helping the economy, some industries will deal with huge challenges that could threaten their profit growth for years to come.
What investors expect from earnings season
As we've seen in past quarters, investors came into the beginning of earnings season having lowered their expectations dramatically. Analysts currently expect earnings growth for the quarter of just 1.1% for the stocks in the S&P 500, according to research from FactSet. That's down sharply from the 8.4% growth rate that market participants expected from the fourth quarter just a few months ago, showing the extent to which downward revisions have hurt investor confidence and explaining some of the downward moves the market has suffered recently.
Obviously, the energy sector is a huge part of the reason why earnings expectations have fallen so sharply. In late September, investors expected the energy sector to grow earnings by more than 8% this quarter compared to a year ago. Now, expectations are for a decline of 19%, and more than half of energy companies in the S&P have cut their earnings estimates by at least 20%.
Yet several other sectors have seen investors downgrade their prospects substantially. Like energy, materials and financial stocks have both had initial expectations for earnings gains reversed to losses. Telecom stocks have also seen a big decline in earnings-growth projections, going from just over 41% in September to 27.5% largely as a result of a 13% reduction in what shareholders believe Verizon's (NYSE:VZ) earnings per share will be. Indeed, all 10 sectors of the S&P have seen at least some decline in expected earnings growth, albeit not to the same extent as these sectors.
What's ahead for the market?
Admittedly, most earnings seasons follow a similar pattern. Sentiment is typically at its lowest point just as earnings season starts. As the season progresses, the eventual numbers usually turn out to be better than what investors expected at this point.
Yet there's reason to be concerned with the level of negative sentiment right now. Even though companies tend to front-load negative earnings warnings, the 81% of companies giving guidance so far for this quarter have made downward adjustments is much higher than the typical figure of just over two-thirds. Moreover, revenue growth will also likely be tepid, with the expected 1.1% growth rate being less than a third of the average sales growth the market has seen between 2012 and now.
In the end, earnings growth has been the backbone of the bull market rally since 2009, with earnings in the S&P 500 having doubled from its lows six year ago. That makes each earnings season increasingly important for investors to look at closely. If earnings can once again defy negative sentiment and grow more quickly than expected, then investors could see continued gains for markets. But if earnings growth slows, then stocks could finally give in to downward pressure that could result in a long-awaited correction for the market.