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US earnings season - is it living up to the hype?

Is the U.S. earnings season living up to the hype?

Earnings season is here, and investors are watching avidly as large companies reveal how much profit they made in the first three months of 2018. Their keen interest is understandable. It’s been an eventful quarter, after all.

Have U.S. President Donald Trump’s tax cuts had a significant effect on U.S. corporate profits? What about the equity market volatility in February and March? Or the weaker-than-expected purchasing managers’ indices that appeared to take analysts by surprise at the beginning of the year?

High hopes

The world is looking to the U.S. – home to the world’s largest stock market and economy – for answers to these questions. Heightened expectations for company profits have been around for some time.

Forecasts for this U.S. earnings season were high to begin with, and have remained that way. Analysts usually make an initial prediction for a given company’s earnings and then have the opportunity to revise their estimate as the announcement date draws nearer.

The balance of analysts’ earnings upgrades to downgrades is shown by the earnings revisions ratio, with a positive number indicating that more upgrades are taking place. This season’s reading is the highest in the history of the series, exceeding even that of spring 2009, when the recovery from the global financial crisis was under way.

Analysts have been upgrading their earnings estimates

Source: Thomson Reuters Datastream, I/B/E/S, April 26, 2018.

Such optimism at this late stage could be unusual. In the past, analysts have tended to lower the bar as the season begins, with the result that more companies may either meet or beat their expectations.

Whether or not this process is contrived is up for debate, but it has not been much in evidence this time around. Without such help, so to say, will the percentage of companies that beat or meet forecasts be lower?

Estimates for growth in earnings per share (EPS) have also been very high. Currently, this figure sits at around 23%, although some analysts who omit more volatile parts of the market, such as energy stocks, in their calculations estimate around 21.4%.

EPS growth for the first quarter in 2017 was also high at 15.3%. In combination, the earnings revision ratio and EPS growth estimates appear to paint a very appealing picture for investors in U.S. equities.

So why are expectations so high? Many observers attribute the positivity to optimism about the effects of Trump’s tax cuts and longer-term trends of improvement in the global economy. In addition, recent dollar weakness may provide a boost to U.S. exporters, as it makes their products cheaper for international buyers.

The earnings revisions ratio for exporters is currently higher than that for companies with a U.S.-domestic focus, but investors should also ponder the potential implications of increasing global trade tensions for such companies.

Is reality tallying with expectations?

At the time of writing, research from Thomson Reuters showed that 227 of the companies in the S&P 500 Index had made their reports by April 26, with 80% of these beating expectations. According to the same report, the level of positive EPS surprises stood at a respectable 6.8%. Although this represented just under half of the index’s constituents in number, the size of some of the companies that have already made their reports means it accounted for significantly more than half of the index’s overall worth.

Certain stocks are considered to be bellwethers, both for the rest of U.S. earnings season and the global economy.

To have a chance of predicting which way the pendulum will swing by the end of earnings season, we must examine the reaction to some of the important reports that have been made so far. Certain stocks are considered to be bellwethers, both for the rest of U.S. earnings season and the global economy.

Among them is the heavy machinery-maker Caterpillar, which made its statement this week. Demand for its products may indicate strength in the U.S. housing market and increased spending on infrastructure. First-quarter EPS were considerably higher than predictions – coming in at $2.82 vs $2.13. Caterpillar also raised its earnings guidance for the rest of 2018, proclaiming its faith in a continued global economic recovery by anticipating “strong end-user demand.”

The investor response to the news was interesting: initially, Caterpillar’s share price rose sharply, climbing by around 4.5% from the previous day’s close. Things took a turn for the worse once investors had a chance to fully digest Caterpillar’s statement, however, and the shares fell 6.2% over the day. It seems investors were spooked by the emphasis on how strong first-quarter performance had been, fearing that the company has a lot to live up to in order to meet its guidance for the rest of the year.

Will tech triumph?

Alphabet, the parent company of Google, has also been on the receiving end of what could be a trend of “travel and arrive” (i.e. the practice of buying a stock, holding it and then selling it after a particular event has happened or piece of news been received) trading by investors.

Following a similar line to Caterpillar, Alphabet roundly beat expectations for its profits and revenues and its share price rose in the immediate aftermath of the announcement. The optimism quickly wore off, however, and the shares were down 2.6% for the week to Thursday’s close.

The technology sector has been a particular area of interest and speculation in recent months. This is not only because of its domination of the market and the fact it was responsible for much of the S&P 500’s outperformance in recent years, but also because of the recent scandal surrounding social media companies’ alleged misuse of user data.

Facebook has been under particularly high levels of scrutiny, but initially at least, it seems that its earnings announcement has met with much higher levels of approval than that of Alphabet. Facebook shares gained 5.26% over the week to Thursday’s close.

As for Apple, the largest company in the world, it doesn’t disclose its results until the first of May. But early indications from some of its main suppliers were discouraging, with several reporting slowing sales growth towards the end of the first quarter. In the past, such news has foretold of correspondingly poor sales of Apple products.

Another point to consider is whether there will be a resurgence in share buybacks, where companies use “spare” cash to repurchase their own stock. The practice, which has been very popular in the technology sector (super-strong growth meant lots of money was available), reduces the number of shares available on the open market, theoretically increasing the value and potential EPS of those which are left behind.

Share buybacks are currently estimated to account for around 1.9% of EPS growth, but there is a blackout period for these transactions for a some weeks in advance of an earnings announcement, and usually for a few days afterwards. In the coming weeks, investors may be very keen to find out which, if any, large companies decide to take such action.

Important Information

Companies mentioned for illustrative purposes only and should not be taken as a recommendation to buy or sell any security. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list.

Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially. Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. You cannot invest directly in an index.

ID: US-300418-64146-1