Q2 2017 is almost over. Earnings season is next month. As usual, the banks will kick off Q2 earnings season in mid-July while the tech companies will issue earnings reports in late-July.
Historically, the correlation between earnings season and the S&P’s returns has been mixed. A “strong” earnings season that mostly beat analysts’ expectations will push the S&P higher more often than it will push the S&P lower (i.e. sell the news). However, this is not always the case. For example, Q2 2016 earnings season was very positive with most of the major banks and tech companies beating expectations. However, the S&P was completely flat.
Still, it’s important to look at earnings season. It’s one component of our discretionary outlook. We look at 2 things:
- How strong earnings growth is year-over-year and quarter-over-quarter. This impacts our long term outlook and our model.
- Whether earnings reports are beating or missing analysts’ expectations. This can impact the overall stock market in the short term but has no impact on the stock market in the medium-long term. Earnings can be falling but as long as analysts lower their earnings estimates fast enough, the earnings reports will still “beat expectations” and appear strong (in Wall Street lingo). It’s a ridiculous game that everyone plays, so we have no choice but to watch this as well.
Here’s a preview of Q2 2017 earnings season.
The real strength of earnings
Analysts estimate that the year-over-year earnings growth rate for the S&P will be 6-7% in Q2 2017. Keep in mind that analysts tend to underestimate earnings. For Q1 2017, they estimated earnings to be 9% while it came in at 13.5%! Hence, we think the correct estimate for Q2 2017 should be around 9%. This is lower than last quarter’s year-over-year growth rate, but is still very solid growth. This is a bullish factor for this bull market in equities.
So why is the growth rate falling a little bit? We need to look at the main contributors for growth.
The energy sector
The energy sector is the main driver for earnings growth. In fact, the increase in energy sector earnings accounts for almost 44% of the S&P’s estimated earnings growth rate!
The energy sector’s year-over-year earnings growth relies heavily on year-over-year changes in oil prices.
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- Oil prices soared from Q1 2016 to Q1 2017 (because oil crashed in Q1 2016).
- Oil prices went up much less from Q2 2016 to Q2 2017. The average price of WTI crude in Q2 2017 will be $48.8, while the average price of WTI crude in Q2 2016 was $45.5.
Here’s the weekly bar chart.
The falling growth rate for energy earnings is why the S&P’s earnings growth rate will be lower in Q2 2017 than Q1 2017. The materials sector’s growth rate will also fall because commodity prices as a whole have been falling in Q2 2017. However, commodity-related sectors do not determine the S&P’s long term earnings growth. Finance and tech – the S&P’s 2 largest sectors – determine the S&P’s long term earnings growth. Overall, the earnings growth supports this bull market.
Analysts expect 401% growth in year-over-year energy earnings. This growth rate is sky-high because many energy companies were losing money in Q2 2016.
Finance was the second biggest cause of Q1 2017’s strong earnings growth. Interest rates impact banks’ profit margins. When rates rise, banks’ profit margins widen. Interest rates went up from Q1 2016 to Q1 2017. The increase in interest rates has also been significant from Q2 2016 to Q2 2017.
Here’s the chart for the 10 year Treasury yield.
We think that finance earnings will continue to be a strong contributor to Q2 2017 earnings growth. Although interest rates in Q2 2017 are lower than they were in Q1 2017, interest rates in Q2 2016 were also lower than they were in Q2 2016. So the year-over-year increase in interest rates is comparable.
Analysts expect financial earnings growth of 6.8%. We think it will be higher.
The energy, finance, and tech sectors are expected to be the main contributors for earnings growth in Q2 2017. This is the same as Q1 2017, except tech has become stronger than finance.
This makes sense. Tech companies like Amazon are eating everyone’s lunch.
In fact, the tech companies are corroborating analysts expectations. Tech companies are the most upbeat about their earnings growth, with many of them issuing positive earnings guidance.
Analysts expect the information technology sector to experience 9.4% year-over-year earnings growth.
Vs. analysts’ expectations
Most earnings seasons beat analysts’ expectations. This is because the companies always “guide” analysts to lower expectations, and then beat the expectations. This is a ridiculous game that Wall Street loves playing.
Thus far, around two-thirds of companies have issued negative earnings guidance. Companies are setting their earnings reports up for any easy “beat”.
Once again, the S&P doesn’t always go up during a “strong” earnings season that beats analysts estimates. But it does go up more often than it goes down.
Hence, the odds of the S&P making a “small correction” in mid-late July (during earnings season) is low. The S&P will probably either consolidate or continue to rally in mid-late July 2017.
This fits with our idea that perhaps the S&P won’t make a small correction right now. Perhaps it will wait until September-October before making a small correction.
A major boon to earnings in Q4 2017 and 2018
The U.S. dollar is falling. A falling U.S. dollar boosts the revenues for U.S. companies because 50% of the S&P’s earnings come from overseas. These companies release their earnings in USD.
However, the falling U.S. dollar is not a boon to corporate earnings right now. This is because the year-over-year change in the U.S. dollar has not fallen. The year-over-year change in the U.S. dollar impacts earnings growth.
Here’s the USD Index’s chart.
By Q4 2017, the U.S. dollar will have fallen year-over-year. This will provide an additional boost to earnings in Q4 2017 and 2018.