Beating the Earnings Blahs

Spring may be here, but headlines are warning investors to brace for a nasty storm: Q1 earnings season. Most expect it to be a stinker, with consensus forecasts for a -1.4% drop in aggregate S&P 500 earnings from Q1 2013. Some say the expected weakness is a blip, with stronger earnings growth on tap in 2014’s second half; others claim it’s a sign firms can no longer offset weak revenues by cutting costs. While we side more with the optimists, we take a different view overall: Expectations are just expectations. Reality isn’t guaranteed to follow, and even if earnings are weaker, it doesn’t mean the bull must end.

Weak forecasts are nothing new. For most of this bull market, analysts’ expectations have started the quarter reasonably positive, then fallen steadily as firms lower their guidance, reaching rock-bottom levels just before companies start announcing. But once earnings season begins, a funny thing usually happens: Firms broadly beat expectations, and the final tally ends up higher than most anticipated. Those lower expectations, so widely feared before companies report, end up creating a positive surprise down the road.

This is largely why companies lower their guidance. Think about the typical headline on a company’s earnings results: “Company X Earnings Beat on A, B and C!” or “Company Y in Earnings Miss on D and F!” The actual direction of earnings is rarely mentioned—the headline win or loss gets all the attention and, by extension, is what influences investor sentiment. So companies are incentivized to set expectations as low as possible, simply to raise the likelihood they beat. That’s how you regularly get over two-thirds of companies beating expectations every quarter. They purposefully set the bar low for themselves.

Whether firms broadly beat this quarter remains to be seen—earnings season is only just kicking off, and while headlines tell you the first few “bellwethers” set the course for everyone else, seldom does it turn out that way. We’ll have to wait several weeks to get a sense of how aggregate earnings will look—until at least half the S&P has reported, it’s too premature to make judgments.

Not that folks aren’t trying. Many assume the frigid winter put a chill on sales, and they expect a torrent of weather-related misses. Perhaps they end up right. Weather messed with several economic readings in January and February, and earnings could end up another victim. Then again, one would assume weather would ding revenues—and even with expectations dialed down, revenues are expected to accelerate in Q1 (a factoid that, bizarrely, most of the pre-season earnings coverage omits).

Note, we aren’t saying folks should expect blazing Q1 earnings growth—and it’s entirely possible earnings could fall in line with or even below expectations. But even if Q1 earnings season is a dud, it shouldn’t much matter for the bull market. It’s normal for earnings to slow or even fall on occasion during a maturing bull market—and for the bull to keep on running. The longer a bull runs, and the longer earnings grow, the harder the year-over-year comparisons become to beat. In the 1990s bull, for example, earnings growth started decelerating in 1995, turned negative in 1999, then rebounded some before the bull ended in 2000. From a pure earnings standpoint, the second half of the 90s looked blah—but for stocks it was anything but. Weak or negative index-level earnings growth doesn’t mean every company is teetering. It just means results are more varied and earnings growth is a scarcer commodity.

The scarcer a commodity becomes, the more folks have to compete to own it. When earnings become more variable and growth more rare, investors have to compete more for a share in those companies still growing. They have to bid higher, driving prices up. This is a large reason why the biggest, most stable companies tend to perform best as bull markets age. Companies with strong global revenue streams and more flexible costs tend to have the highest gross margins (revenues minus cost of goods sold), giving them the highest likelihood of earnings stability. Smaller companies with relatively fixed costs, by contrast, tend to have the most vulnerable earnings late in a bull. The largest firms tend to benefit the most from the late-bull earnings bidding wars.

Five years into this bull, with earnings growth so broad based, we haven’t seen this yet—a big indication we aren’t anywhere near as far along in this market cycle as headlines continually suggest. With several economic indicators pointing to still-strong global growth, sentiment still fairly evenly split between skepticism and optimism (just like earnings pre-season headlines!) and no big, bad, largely unseen risks on the horizon (that we can spot), this bull should keep on running even if we get a sad quarter or two of earnings.