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Market Commentary - 5.2.12

What Have We Learned From Earnings Season?

Historically speaking, the stock market takes its direction from many indicators such as where we are in the economic cycle, monetary action from the Federal Reserve, overseas happenings and political events in Washington. While these factors can help shape market performance, one key indicator that has been the primary driver of stock market performance over the long term is corporate profits. As corporate profits trend higher, the stock market has generally followed.

With earnings such an important component of market performance and the fact that we are about one month through earnings season, let's review what we have seen so far from Corporate America. Using data supplied from Thomson Reuters, we have primarily witnessed three observations.

Let's start with the good news. Of the 275 companies in the S&P 500 that have reported first quarter 2012 earnings through April 27th, 72% have reported earnings above analyst expectations. This is higher than above the long-term average of 62% and the average over the past four quarters of 68%. The fact that positive surprises are above trend suggests possibly diminished analysts' expectations going into 2012. Nevertheless, this is clearly good news and one reason for the strength that we have seen in stocks this year.

Unfortunately, we have also seen some less-than-stellar earnings news. So far for the first quarter of this year, the earnings growth rate of the S&P 500 is 7.1% and if we exclude Apple Incorporated (AAPL), the overall growth rate declines to 4.7%. This overall year-over-year growth rate is disappointing relative to the high single/low-double-digit growth we had seen for the past few quarters (see table below). Furthermore, according to Thomson Reuters, while second quarter 2012 year-over-year earnings growth is expected to rise 9.8%, this estimate for the quarter has dropped from 10.1% on January 3rd and 14.3% on October 3rd. Though expected given the sharp profit bounce back from the Great Recession, this decline in earnings estimates is troublesome and could possibly weigh on equities in the near-term.

Year-Over-Year Earnings Growth Rate
4Q 20113Q 20112Q 20111Q 20114Q 2010
S&P 5009.2%18.0%12.1%18.9%37.2%
Source: Thomson Reuters

Also noteworthy, in the S&P 500 through April 27th there have been 31 negative earnings-per-share (EPS) preannouncements issued by corporations for the second quarter of 2012 compared to just 10 positive EPS preannouncements. This ratio of 31 negatives to 10 positives is 3.1, which is worse than the prior quarter's figure of 2.67 and the year ago figure of 1.27 (lower is better). Moreover, according to Thomson Reuters, this 3.1 figure is well above the long-term aggregate (since 1995) of 2.3. The increasing occurrence of negative earnings preannouncements to positive preannouncements is a troubling trend.

Despite the mixed first quarter earnings results, we are not taking a bearish tone and suggesting avoiding the equity markets. Instead, we would keep equity exposure in line with investment objectives. Within equities, we would continue to focus on dividend stocks as their income component allows them to help mitigate market volatility. We would also maintain an overweight to growth companies relative to value companies. As earning growth likely continues to slow for the entire market, we expect investors to target companies that have historically offered greater earnings growth potential (i.e. growth companies). Lastly, with market swings likely to increase as we approach the end of earnings season, lingering European debt issues, and Washington politics dominating the press, we continue to find alternative investment strategies a viable investment. Because of their low correlation to traditional stocks and bonds, alternative investments may improve diversification and offer potentially smoother investor experience.

This information compiled by Cetera Financial Group is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The information has been selected to objectively convey the key drivers and catalysts standing behind current market direction and sentiment.

No independent analysis has been performed and the material should not be construed as investment advice. Investment decisions should not be based on this material since the information contained here is a singular news update, and prudent investment decisions require the analysis of a much broader collection of facts and context. All economic and performance information is historical and not indicative of future results. Investors cannot invest directly in indices. This is not an offer, recommendation or solicitation of an offer to buy or sell any security and investment in any security covered in this material may not be advisable or suitable. Please consult your financial professional for more information.

While diversification may help reduce volatility and risk, it does not guarantee future performance. Additional risks are associated with international investing, such as currency fluctuations, political and economic instability, and differences in accounting standards.

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