An Earnings Season Replay?

It appears analysts have been slow to react to the lesson economics taught them just a few months back: The strong dollar may ding revenues, but it has some pretty big bottom line benefits, too. This was the lesson taught in Q1, when S&P 500 earnings handily beat too-dour expectations. It's early, but with about 12% of S&P 500 companies having reported for Q2, the same is happening. Thus far, Q2's earnings reality suggests profit expectations remain too low, possibly setting up more positive surprises going forward.

At the end of Q1, just before firms began reporting earnings for the quarter, analysts were dour, expecting S&P 500 profits to drop -4.6% y/y-down from +4.1% projections as the quarter began. The dour outlook was largely based on the strong US dollar, which many feared would materially dent both the quantity and value of US exports. A strong dollar makes US goods more expensive to foreigners, causing some to choose cheaper alternatives. And if US firms don't adjust prices, a stronger dollar means lower revenues after conversion.

Yet the expected decline didn't come-earnings ended up growing +0.8% y/y (+8.6% excluding the Energy sector). It appears analysts didn't quite account for the fact the strong dollar means firms' foreign-sourced input costs fall, too: labor, raw materials, components and transportation. In addition, while many fixate on weak oil prices' potential impact on consumers, they miss the direct positive impact on producers' profits-lower energy and shipping costs are an immediate boon for profits. All simple "on the one hand, on the other hand" economics Harry Truman probably would have hated.^[i]

Despite the positive Q1 earnings surprise, expectations remain subdued for Q2. At the outset of Q2 reporting, analysts anticipated profits would contract -4.5% y/y. But as of July 17, with 62 S&P 500 companies having reported, many have beat expectations. The blend of actual results and analysts' latest estimates is already up to -3.4%. (Ex-Energy, analysts expect Q2 profits to rise +2.7%.) And that's with only 12% reporting! The start of Q2 looks a heckuva lot like a replay of Q1: earnings estimates gradually rising throughout earnings season as analysts realize the strong dollar is not nearly as net negative for profits as they thought. That analysts continue to be overly dour to start the quarter shows the gap between expectations and reality remains bullishly wide.

Should Q2 earnings end up exactly repeating Q1-beating expectations but with flattish headline growth-that may not seem so hot on an absolute basis. Now, as the aforementioned figures show, this is a function of Energy profits cratering-a widely known byproduct of falling oil prices. A repeat of that seems likely, too. But even if profits finish flattish excluding Energy, absolute earnings growth is less relevant than the difference between expectations and actual results. Flat profits are a tailwind for prices if investors generally expected contraction. For example, for most of 2009 year-over-year profit growth was deeply negative. Q1, Q2 and Q3 S&P 500 year-over-year earnings were down -35.4% y/y, -26.9% and -15.7%, respectively.^[ii] Yet markets zoomed higher after March 9 because investors discounted Q1 and anticipated even worse to come-basically, doomsday. This is not to say stocks are about to explode higher like back then, as pessimism in March 2009 was about as extreme as it ever gets, but it shows stocks don't need strong absolute earnings to move higher. Heck, in the first three quarters of 2013, earnings grew 3.9%, 2.1% and 4.0%.^[iii] Stocks surged. Better than expected is good enough.

Of course, factors beyond earnings affect stocks too, potentially offsetting the positive surprise of better-than-expected earnings. But that analysts continue to bake in false strong-dollar fears means their persistent skepticism sets up potential positive surprises. Year-over-year earnings may not be gangbusters right now, or even nicely positive, but as long as they are better than analysts thought, the stage is set fundamentally for stocks to move higher.