Earnings season for the second quarter of 2012 has started, and given that analysts are projecting a year-over-year decline for the first time since 2009, the market has been understandably jittery heading into the reporting period. However, recent history has shown that Wall Street seems to prefer an overly pessimistic view regarding their earnings estimates, and companies may again clear a potentially low-set bar with room to spare.
In this week's interview, Equities.com asked Sam Stovall, Chief Equity Strategist for S&P Capital IQ, for his thoughts on the impact of the global slowdown on earnings and what implications it may have on the rest of the year.
EQ: Earnings season has officially kicked off, and despite very weak expectations to begin with for Q2 results, does seem like we're already off to a shaky start?
Stovall: Yes, it does. The market has been sliding ever since we experienced the "compromise catapult," in which the market soared after the Europeans seemed to agree as to how they will address the Spanish debt problem and other issues following the European summit. But it seems as if that strength was something investors decided to sell into. Also, we've expected second quarter earnings to be relatively weak, and so far, we've not been disappointed in that sense.
EQ: In the last several quarters, we've observed that corporate management has been effectively lowering expectations only to beat them. Do you think the market is catching on and now may be conditioned to expect companies to beat estimates significantly?
Stovall: You would think so, but it seems as if the analysts continue to take a bite of that apple and assume the results will be a little bit different. When we look to 2011, the average difference between the S&P Capital IQ consensus earnings estimates and the actual results was more than 5 percentage points. It was as high as 7.5 percentage points in the first quarter, and as little as 1.2 points in the fourth quarter. Regardless, when the market expects 13 percent and you get 19 percent, and it's fairly consistent all the way through, you would think that analysts would catch on, but they certainly have not.
So as we enter into this second quarter reporting period, the expectation is for a 1 percent decline. If you take that average of 5 percentage points and factor that into what the second quarter estimate is today, it would imply--but certainly not guarantee--that we could see about a 4 percent increase in earnings for the quarter. That would still put us in record territory. However, the rate of change would be slowing quite dramatically, falling from a high of nearly 20 percent in the first quarter of 2011 to the potential low-to-mid single digits for the second quarter.
EQ: Technology was one sector that was expected to report EPS growth, but seems to be weighing on the market as early reporters cut their outlook, citing weaker demand from China and Europe. Was this already expected though, given that the slowdown in those markets have been well-documented?
Stovall: It has been relatively well-documented. Europe is expected to show a 0.6 percent decline in real GDP in the second quarter, and slipping to a 0.7 percent decline in the third quarter. China is expected to show full-year 2012 GDP growth in the mid-to-high 7 percent area, as compared with the low 9 percent area in 2011. So it certainly really should not be coming as too much of a surprise, yet I think investors have been disappointed by results by Advanced Micro Devices, Inc. (AMD), Micron Technology Inc. (MU), and SanDisk Corp. (SNDK), and as a result, those shares tumbled because of the weaker-than-expected earnings results. So even though maybe they were anticipating to see some red numbers, those numbers ended up even redder than investors expected, and the market responded by selling off.
EQ: You noted in this week's Sector Watch that economic weakness in Europe, slowing demand from emerging markets, weak consumer spending in the U.S., and a stronger dollar will likely be cited as challenges for earnings. Do you anticipate these factors weigh on the 14.3 percent EPS growth for Q4 as well?
Stovall: I think that hits the nail on the head. Whatever guidance is offered, we want to see how it's going to affect the back-end loaded earnings growth of more than 14 percent for the fourth quarter. Investors be a bit skeptical of that elevated number, but we ended up getting about a 7.5 percent growth in the first quarter, and who knows what we're getting in the second quarter. We're also expecting a 3 percent growth in the third quarter, and a 14-plus percent growth in the fourth quarter. You really can't point to easier comparisons because the S&P 500 gained more than 8 percent on an earnings basis in the fourth quarter of 2011. So it's not as if we've come off of very low earnings the year before.
So I think some investors were hoping that by the fourth quarter of this year, Europe will be emerging from recession, China would have been able to engineer a soft landing as well as start to work it's way out of that soft landing, and that we'd also start to pick up the pace in the U.S., but apparently that's not something that is being projected right now. Therefore, guidance will be very important as to what it will mean for the full year. Currently, the EPS estimates for the S&P 500 is $105 for the full year of 2012, representing a multiple of 13.5. However, if we end up being closer to last year's $100, we could end up slipping back to a multiple of as low as 12, which would bring us back to levels that we saw in the latter part of 2011.
EQ: We've discussed before, larger-capped corporations on the S&P 500 do carry more influence on the index. Does that also imply that if these large-cap companies are able to report stronger earnings, they can mask the potential weakness seen in the rest of the economy through the much smaller stocks on the index?
Stovall: Yes, I would say that can be a problem. If the larger companies--which tend to have a wider reach in terms of sales and distribution channels, more favorable contracts with suppliers, and so forth--are able to hold on a little bit longer and little bit better than their smaller competitors, we could find that the earnings growth ends up being a little bit better than the median would be and, as a result, equity prices end up holding up a little bit better. With that said, that's also another reason why investors gravitate toward large-cap issues during periods of economic weakness. There's an old saying that if the ocean starts to get rough, investors prefer a larger boat. So basically, during challenging periods in the overall economy, investors tend to favor the larger-cap issues as compared with the small cap ones.
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