About Those Dreadful Earnings Expectations

Earnings season kicked off this week, and expectations are ... not great. "Worst earnings season since the financial crisis" is a common theme, as pundits warn the fourth quarter of this so-called earnings recession bodes ill for stocks. Analysts have ratcheted down their forecasts even more than usual, and hopes for positive surprise are few and far between. Regardless of how Q1 earnings shape up, however, we suggest not getting caught up in the hype. Stocks look forward, not backward. Whatever drove Q1 earnings, be they dreadful or ok, has already happened. Stocks have lived through it, discounted it, and moved on. How stocks perform from here depends on what is likeliest to happen over the next 12-18 months or so, and there are good reasons to believe corporate profits will resume growing sooner rather than later.

When Q1 began, earnings expectations were ok. Consensus estimates called for S&P 500 earnings growth of 0.7% y/y, with the primary drag an expected -41.7% drop in Energy earnings.^[i] All other sectors except Materials and Industrials were expected to grow. Three months later, however, any lingering optimism was gone. By March 31, analysts expected S&P 500 earnings to fall -9.4% y/y-and still be negative even if you remove Energy earnings' projected -104% y/y decline. Financials and Materials earnings are also expected to fall double digits, and only Consumer Discretionary, Health Care and Telecom are projected to rise.

That all sounds rather dismal, and it's natural to feel pessimistic when surrounded by such dreary forecasts. But these are just that: forecasts. Projections. Expectations. Time will tell whether they're on target, too optimistic or too pessimistic-all three are possible. But there are a few reasons why they might be at least a shade too dour. Throughout this expansion, analysts have knocked down their estimates for a given quarter as the quarter progressed, only for results to surprise positively. Entering Q1 2015's earnings season, analysts expected S&P 500 profits to fall -4.6% y/y. But they grew 0.9% y/y and, excluding Energy's -56.6% y/y drop, the other nine sectors' earnings rose 8.7% y/y. We saw similar in Q2 and Q3. Even though S&P 500 earnings fell each quarter, they beat expectations. Q2 earnings were supposed to fall -4.5% y/y-they fell just 0.7% y/y and rose 5.9% ex. Energy. Q3 earnings were also supposed to fall -4.5% y/y-they fell just -1.5% y/y and rose 5.6% ex. Energy.

Now, just because analysts were too pessimistic much of last year doesn't mean they're automatically too pessimistic now. After all, their expectations for a -4.7% earnings drop in Q4 proved too optimistic, as earnings actually fell -5.5% y/y (though, stocks rose that quarter-your first clue that stocks and earnings aren't joined at the hip). But we also know, from repeated experience, that consensus earnings forecasts tend to react to market volatility, presuming a correction must mean stocks are pricing in something bad. Yet corrections are products of sentiment, not fundamentals. Stocks' January/early-February slide had everything to do with emotions. For better or worse, very little actually changed. Economic data were mixed but still largely growthy, in the US and globally. For those who overrate currency moves and (wrongly) fear a strong dollar kills multinationals' earnings, the dollar actually weakened in Q1. Oil fell again, but any oil-related negatives hurt Energy firms only. For Consumer Discretionary firms and energy-intensive businesses, cheap oil is a boon. Everyone worried about China, but monthly data show China grew fine throughout the quarter. Far be it from us to be Pollyanna here, but the potential for at least some positive surprise seems high.

At the same time, overemphasizing Q1 earnings-whether they're good or bad-is too backward-looking. Stocks have already moved on. That's just what forward-looking markets do. That doesn't mean the occasional bad (or good) earnings report can't trigger some short-term volatility, but that's just sentiment. Fundamentally, stocks will weigh what's likeliest to happen over the foreseeable future-and in that window, earnings should do ok. For one, as oil prices stabilize, Energy earnings should stop suffering double- and triple-digit drops, removing some huge downward skew from aggregate S&P 500 earnings growth. Energy earnings have fallen to a very low base, and sooner rather than later, growth rates should improve even if absolute profits don't soar. Even if Energy earnings just bounce around, one powerful earnings drag vanishes.

The same holds for the rest of the S&P 500, albeit to a lesser extent. It's quite normal for earnings growth to pause or even reverse in a maturing bull market, as year-over-year comps become more difficult to beat after years of rising profits. A negative quarter or three helps reset that baseline, creating an easier hurdle for firms to beat. That tends to tee up a reacceleration in the bull's final years, as we saw in the late 1990s. We could easily see this with Tech, Financials and other sectors, particularly as their outlooks improve. For Tech, demand for hardware and software alike remains strong as firms continue upgrading IT systems and mobile and cloud computing drive demand for all manner of products and services. For Financials, as ad hoc regulatory costs (tied mostly to the Financial Crisis's legacy) fade into the rearview, strong loan growth and capital markets activity should bolster revenues.

For what it's worth, analysts presently expect earnings to grow in calendar-year 2016. Aggregate S&P 500 earnings per share are expected to rise 2.1%, with Energy (-62.8%), Materials (-3.0%) and Telecom (-6.1%) the only minuses. These expectations will probably evolve throughout the year, as analysts continue reacting to the latest and greatest, but for now, the optimism seems plenty rational to us.

For the moment, earnings are expected to turn positive in Q3, but that shouldn't mean stocks will struggle until then. Stocks regularly move before earnings do. We saw it in 2009, when the bull market began while earnings were still plummeting-something many of these "eek, worst earnings since 2009" headlines unwittingly reminded the world of. Stock prices show how much investors are willing to pay for future earnings, so it's logical that investors bid stocks up or down in anticipation of what comes next, not on what just happened. So stay cool, and don't get caught up in Q1 numbers. Stay focused on your own goals and financial future, as well as what's likeliest to happen from here. That will have little to nothing to do with what happened in January, February and March.