By Dee Gill
Earnings season officially kicked off a couple of weeks ago, but worries about it in corporate boardrooms began festering months ago. Since early 2013, investors had been primed for strong earnings growth beginning the second half of the year. It was clear by July that many investors would be disappointed. By Tuesday, some 90 companies had issued guidance aimed at tamping down expectations for the third quarter, according to FactSet.
Market wide earnings growth forecasts since June were slashed by half.
So this earnings season presents a moment of truth for many companies: Will their third quarter results mark them as among the growing list of disappointments, or will they fulfill investors' still-strong hopes of growth ahead?
It's an important question because investors have not really reset their bullish expectations about 2013. FactSet's consensus calls for 10% earnings growth in the fourth quarter, which looks huge next to the 3% growth they expect this earnings season. The S&P 500 is up about 2.5% since June 30, and shares are now trading at an average of 14.2 times 2014 earnings. That's well above 5-year and 10-year averages, according to FactSet, and a particularly strong forward PE ratio amid Congressional dooms-making of late.
Even stocks of the companies that published the biggest downward revisions to third quarter forecasts are mostly doing okay. Seven of the top 10 down-graders are trading at or higher than they were at July 1. Illinois Tool Works (ITW) and KLA-Tencor (KLAC) are up about 7% each since then, and they're still carrying big gains respectively since the beginning of the year.
ITW data by YCharts
In other words, many investors are betting that the big profit boom has simply been delayed, not permanently denied. And they expect the results out this earnings season to prove them right.
Profit margins reported in earnings announcements will give us clues about whether such optimism is warranted. Across-the-board revenue growth for the third quarter is estimated at 2.6% and a measly 1% in the fourth quarter. So for many companies, margins need to grow in order to hit earnings-growth targets.
Nut seller, Diamond Foods (DMND), demonstrated how that might be done with its latest quarter report. Although revenues were down 10.8%, it beat the market's estimates for profits by a long shot through radical cost management. Gross profit margins expanded 770 bps over a year earlier, allowing profits to surge. But warnings that the next quarter's sales and earnings would be lower than a year earlier dropped its share price.
DMND data by YCharts
Results this earnings season also will help investors judge which parts of the world they should look to for growth. Although many investment advisors say it's time to buy stocks with European exposure, not everyone is convinced it's safe yet. Comments about business in Europe from Ford (F), McDonalds (MCD), General Electric (GE), Coca-Cola (KO) and other companies with high exposure will help determine a lot of asset allocations this winter.
Investors also are looking for more clarity on China this earnings season, which has been a drag on some multinational shares. Although KFC owner YUM! Brands (YUM) just produced horrific results from China - bad enough for it to slash its overall fourth quarter earnings forecast - it had unique problems there. (The public's fear of eating chicken during an Asian flu outbreak, for one.) Investors are looking for words of encouragement or caution about China from companies like Caterpillar (CAT), United Technologies (UTX), Proctor & Gamble (PG) and Joy Global (JOY).
So far this year, the market has been pretty forgiving of lowered forecasts. But expectations are still high, as seen in that double-digit earnings growth figure FactSet's consensus shows for the fourth quarter. Watch for signs that somebody's about to get hurt.