Earnings: the Stock Market's Achilles Heel

Sheraz Mian, Director of Research, Zacks Investment Research

Reasonable people can disagree over what forces have driven the stock market to all-time highs. But no one denies the centrality of earnings to stocks, and for good reason: the whole point of investing in stocks is to share in a stream of future earnings.

So, since stocks are doing great, earnings must be doing at least very well. Are they?

My answer is no. I think the market is pricing in an unrealistic forecast of future earnings that is unlikely to play out. This, in my judgment, is the weakest link in the current positive stock market narrative—the Fed's potential QE exit notwithstanding.

It might surprise you to learn that earnings growth has been essentially nonexistent over the last few quarters, including Q2. Despite that fact, consensus estimates predict earnings growth to resume later this year and accelerate into 2014.

I'm skeptical. To be clear, I'm not suggesting an earnings train wreck, nor am I telling you to sell all your stocks. What I am suggesting is that the broad market is vulnerable to negative earnings revisions, which could cause the stock market to give back some, if not all, of its recent gains.

Let's take a look at what the data are telling us, to glean whether it's time to reposition your portfolio for weakness ahead.

How Good Was the Q2 Earnings Season?

By most conventional measures, the Q2 earnings season was similar to that of Q1. You might describe both as "good enough" or "average."

But digging a bit deeper, we find that much of the respectability for Q2 earnings emanates from one sector alone—finance. If you strip out finance, the Q2 earnings season is decidedly below average.

494 S&P 500 companies have reported Q2 results as of Friday, August 29. Their earnings are up +2.5% since Q1, with 65.6% of companies beating their earnings expectations. Total revenues are up +1.9% over the same period, with 51.8% of companies beating revenue expectations.

The two side-by-side charts below compare Q2 earnings growth with that of Q1 and the four-quarter average. The left chart compares the results across all companies, and the right one compares the results across all companies excluding finance.

(Click on image to enlarge)

Note: The data compare the growth rates for the 494 S&P 500 companies that have reported results, as of Thursday, August 29.

As you can see, the finance sector's strong performance in Q2 masked an otherwise poor quarter for the rest of the S&P 500.

Importantly, finance is no small fry. The sector accounted for almost 21% of all S&P 500 earnings in Q2, the highest of all 16 Zacks sectors (technology accounted for 16.5% of total earnings in Q2).

But there's a big world outside of finance, and it's hard to be satisfied with nonfinancial companies' Q2 earnings performance.

Expectations for the Coming Quarters

Earnings expectations for the second half of the year have started to decline. Companies have been issuing lower guidance on Q2 calls, resulting in a particularly steep decline for Q3 estimates.

The chart below shows how estimates for Q3 have evolved over the past month:

What's troubling is that even with these downward adjustments to Q3 expectations factored in, estimates for the second half of the year still represent a material acceleration in growth from the first half, particularly for sectors other than finance.

You can see that the loftiest of expectations are for Q4 2013:

To provide further context, the following charts illustrate quarterly earnings totals (and projected totals) instead of just the growth rates:

As you can see, earnings are already at an all-time record level. But they are expected to go much higher in the last quarter of the year.

Further, 2014 isn't pictured, but those expectations are even loftier: consensus expectations are for earnings to grow +11.3% in 2014, and +11.9% for all sectors excluding finance in 2014.

How Realistic Are These Expectations?

I don't think these expectations will pan out. Here's why.

Earnings grow for only two reasons—revenue growth and/or margin expansion. Unfortunately, the outlook on both fronts is problematic.

Margins are already at cyclical peak levels—the best that can be expected on that front is for margins to remain stable.

That leaves revenue gains as the only driver for earnings growth. But you can't have significant revenue gains in the current environment of constrained economic growth. Revenue growth is a direct function of nominal GDP growth, and nominal GDP growth has been lukewarm at best.

The US economy is actually in better shape than most of its trading partners, particularly in the developed world, as the recent positive revision to second-quarter GDP confirms. But Q2's +2.5% GDP growth notwithstanding, the reality is that US economic growth has barely been above the +2% level for the past many years. And the situation abroad has been even weaker.

Bottom line: it's hard to envision companies, particularly outside of finance, growing their revenue significantly in the coming quarters amid tepid economic growth.

So What Gives?

Not only are margins already at record levels, but corporate earnings as a share of GDP are also at multidecade highs. Just like trees don't grow to the skies, margins and the ratio of earnings to GDP don't expand forever.

What all of this boils down to is that current earnings estimates are high, and they need to come down—and come down quite a bit. I think the most likely outcome is for earnings growth to flatten out. Though even that scenario could prove too rosy—it's entirely possible that earnings growth could turn negative.

How Do You Invest in This Environment?

The way to invest in today's environment is to look for stocks whose prices don't reflect aggressive growth expectations, and that enjoy company-specific growth drivers not tied to broader macro trends. Companies that generate plenty of cash flows beyond their immediate capital needs and have track records of sharing excess cash with shareholders through dividends and buybacks are particularly well suited for a period of sub-par earnings growth. Bottom line, look for thematic stocks with strong defensive attributes.

Best,

Sheraz Mian

Sheraz Mian is the director of research for Zacks and manages its award-winning Focus List portfolio.