The lifeblood of the stock market is corporate earning power, and so far in 2015, the upward momentum that the U.S. economy has seen throughout most of the past several years has come to an abrupt halt. For what could be the second quarter in a row, analysts believe that earnings will fall from year-ago levels, and the implications for investors are increasingly troubling as many start to think that a possible end to the bull market in stocks is looming. Let's take a closer look at the coming earnings season and which investors are likely to take the biggest hit.
Another quarter, another threat
The second quarter of 2015 marked a disappointing period for corporate America, with the companies in the S&P 500 reporting a decline in earnings of 0.7% from year-ago levels. That wasn't nearly as bad as the almost 5% drop that analysts had expected, according to data from FactSet Research, but it nevertheless marked a disturbing break in the growth momentum that U.S. companies had enjoyed throughout much of the bull market.
Two things were particularly troubling about the quarter. First, although analysts had originally projected declines in some previous quarters, they had turned out to be overly pessimistic until the latest quarter. Second, revenue growth has been even harder to find, with a 3.4% drop in sales among S&P 500 companies marking the second quarter of falling revenue in a row.
As bad as the second quarter was, the third quarter could turn out even worse. Projections anticipate earnings declines of 4.4% on a 2.9% drop in revenue for the third quarter. It's true that expectations immediately before companies report their results tend to be the least optimistic, and most of the time, the final numbers turn out better than feared at this point. Nevertheless, a second straight quarter of declines would be the first back-to-back drop since 2009 -- which will bring back bad memories of the financial crisis.
Where the damage will hit the hardest
It will come as no surprise that the energy sector will see the most damage from declines in both revenue and net income compared to last year's quarter. This will be the last quarter in which year-over-year comparisons of crude oil prices will be this dramatic, but prices have fallen by more than $10 per barrel just since early July, suggesting that the declines might not yet be over. Natural gas and coal prices also remain under pressure, hurting earnings power throughout the sector.
Yet even though energy's fall has been quite visible, investors haven't yet entirely taken it into account in their valuations in the sector. Despite falling share prices in most parts of the energy industry, earnings multiples based on forward estimates have soared, as the stocks continue to anticipate a near-term bounce in energy prices to bolster future earnings. If that bounce doesn't come -- and it hasn't yet, clearly -- then energy stocks could have further to fall. For the Energy Sector SPDR (XLE 0.43%), which has already dropped more than 15% just since the end of June, that could come as shocking news.
Still, other factors will continue to weigh on earnings throughout the stock market. The strong U.S. dollar has hurt earnings growth on just about every company that does business overseas, and with the dollar remaining at extremely high levels compared to key currencies like the euro and the Japanese yen, the impact on third-quarter earnings will be substantial. Also, although most of the attention from investors has centered on oil prices, the entire commodities market has seen weak prices nearly across the board, and that could hit materials stocks that produce metals through mining operations.
Are there places to hide?
All that said, not all the news will be bad this quarter. A healthy telecommunications sector should benefit from ongoing product releases and a favorable evolution toward higher-profit initiatives, and well-off consumers are boosting their discretionary purchases, thereby helping stocks that sell things like automobiles or that offer retail goods online. Yet the SPDR S&P Telecom ETF (XTL 0.30%) hasn't escaped share-price declines, falling about 6% since the end of June.
Nevertheless, the shift in the numbers could have a bigger impact on market psychology, which itself could contribute to short-term weakness in stocks. That doesn't mean that the business prospects of companies throughout the market are equally under threat, but the perception among typical investors could well become more negative marketwide. That might lead to a scary correction, but it could also produce some of the value inconsistencies that produce lucrative investing opportunities for those who are paying attention.