Once again, selling prompted by a geopolitical event (the downing of Malaysian Air Flight 17) failed to spur a broader correction and instead preceded Friday's rally session to close the week. Even in a week featuring Israel's invasion of Gaza and Russia's slaughter of 299 civilian air passengers, the S&P 500 rose 0.5%. As has been evident all through the past five years, this bull market is resistant to black swans and geopolitical events of all stripes.
The drama around the downed civilian flight, and the dawning realization that Russia was the perpetrator, caused a spike in the CBOE Options Volatility Index, which closed on Thursday at 14.54 after reaching 15.10 midday. But by Friday's close, the VIX had slipped back to 12.06 - even though the Russian-Ukraine crisis remained on full boil.
Investors have determined that anything short of a shooting war involving the U.S. will not disturb the broad market uptrend. The coming week brings plenty of distraction in the form of earnings; the coming two weeks constitute the bulk of the earnings season.
More so that political events, however, earnings now represent the chief headwind. Although bank earnings spurred a modest rally in the financial sector last week, technology earnings were generally greeted by sell-offs - in Sandisk (SNDK), Seagate (NASDAQ:STX), and others. Technology is forecast to be one of the best earnings growth sectors at present - and that's the problem. Earnings expectations, muted heading into the past few earnings season, are high at present. That is leading to disappointment, and setting up a July flop
The Set-up: Accustomed to Upside Surprises
Over the past few years, analysts have chronically underestimated corporate earnings power, and that is likely one of the market's strongest drivers. Routinely, analysts and market watchers predict flat to low-single-digit EPS growth, based on low-ball guidance from CFOs. Instead, EPS comes in at a mid-single-digit growth rates; this provides the market room to rally, even during the normally tough market period of earnings season. But for 2Q14 EPS season, the street is forecasting mid-single-digit growth. If earnings are no better than forecast, we see risks that the market could correct across the remainder of July and into August.
Institutions on Board, Retail Investors increasingly Skeptical
According to Investment Company Institute, just under $9 billion flowed out of domestic equity mutual funds during the week ended 7/2/14. For the preceding five weeks dating back to early June, average outflow from domestic equity mutual funds about $3.1 billion. Mutual fund flows remain a bellwether on individual investor sentiment. According to AAII, retail investor bullishness was a tepid 37.6% for the 7/10/14 week. The bullish-bearish sentiment gap has narrowed from 1,400 bps in mid-June to less than 900 bps at present.
Institutional investors regard retail sentiment as a contrarian signal and thus would view waning retail bullishness as a buy signal. In contrast to retail skittishness, institutional sentiment seems to be improving. We believe institutional sentiment is at least partly reflected in ETF fund flows. ETF fund flows were positive in June and, according to ETF.com, investors poured $73 billion into U.S.-listed ETFs in the first half of this year. ETF fund flows are somewhat muddied, however. Some of that activity may reflect disinvestment by pension fund administrators out of traditional mutual funds and into ETFs with lower fees. And retail investors too may increasingly favor ETFs over funds or individual stocks.
EPS Outlook: Mid Single-Digit Growth
A potentially more reliable and tangible metric of institutional sentiment, in our view, is the level of EPS forecasts by the big banks' sell-side analysts. For years, this group has been guilty of buying into low-ball forecasts from corporate managements. CFOs are incentivized to under-guide, knowing they risk seeing their stocks slaughtered if they provide accurate guidance.
This time, finally, the sell side is forecasting EPS growth in the mid-single-digits. This clear-eyed reality may reflect somewhat more upbeat CFO guidance, but is also acknowledged the disconnect between actual and forecast EPS the performance over the past eight or so quarters. High expectations could be a problem, particularly if the earnings reality is no better than newly aggressive consensus EPS forecasts.
According to Bloomberg, EPS for 2Q14 is forecast to grow by 5.1% year over year, and to increase 6.4% excluding financials (most of the big banks that have reported have topped consensus). According to FactSet, 2Q14 EPS is forecast to increase 4.9%. That would be the second-highest pre-reporting growth forecast since the beginning of 2012; only 4Q13 was higher, with 6.5% forecast growth going in (actual 4Q13 EPS growth topped 8%).
The gap between the consensus growth rate immediately before the reporting period and the actual rate of EPS growth is significant. Since the first quarter of 2012, analysts have forecast 1.3% EPS growth on average for the nine subsequent quarters (through 1Q14). The reality is that quarterly EPS growth has averaged 4.2% over that span, representing a 280 bps premium to pre-reporting expectations.
Second-quarter 2014 EPS performance to date is almost too small to be meaningful, but is still worth reporting. As of 7/15/14, Bloomberg counted 32 companies among the S&P 500 having reported calendar 2Q14 results. On average, total reported EPS at mid-July was up 6.6% year over year, or up 11.5% excluding financials.
Sector EPS Leadership is Cycle-Sensitive
Unfortunately, agencies that compile earnings do not use a standard formula; variations in the prior-year baseline can make for exaggerated or stunted growth. Standard & Poor's, which uses a different basis than Bloomberg, forecasts 10% overall EPS growth in 2Q14. Despite this wide variation in overall 2Q14 EPS growth expectations relative to Bloomberg and FactSet expectations, the relative sector growth rates are telling.
According to Standard & Poor's sector EPS estimates, the best sectors for 2Q14 EPS growth are forecast to be (in descending order): Materials, Telecom Services, Information Technology, Healthcare and Industrials. If you toss out Telecom Services, which is dominated and distorted by Verizon (NYSE:VZ) and AT&T (NYSE:T), the S&P is forecasting average EPS growth of 21% for the remaining four sectors. Argus expects EPS leadership to be concentrated in Technology, Healthcare, and Materials, which we expect to average high single-digit to low double-digit growth on average.
S&P looks for remaining sectors - Discretionary, Staples, Energy, Financials, and Utilities - to average low single-digit EPS growth in the 3% range for 2Q14. Financial Services is the only sector with forecast negative year-over-year comparisons. To date, the money center banks have handily topped 2Q14 consensus expectations. But year-over-year comparisons have still been negative, largely reflecting the sharp decline in fixed income trading volumes.
Among economy sensitive names, only Energy and Discretionary are absent from EPS leadership in 2Q14.
EPS Surprise: Required?
Since the 1Q12 reporting period, investors have gone into quarterly reporting, expecting growth on average of 1.3%; instead, companies have delivered better than 4% growth. As the 2Q14 reporting period plays out, expectations are much higher, whether you use the consensus from FactSet (up 4.9%), Bloomberg (up 5.1%), or S&P (up 10%).
Can stocks sustain their uptrend if earnings only grow 5% in 2Q14? There are two ways of looking at this particular partly-filled cup. The glass-half-empty crowd will warn that stocks have only thrived in prior EPS periods based on the significant beat against expectations, and that merely meeting expectations will trigger selling. The glass-half-full gang will rejoinder that the consensus forecast of 5% growth, if merely met, would still be better than average quarterly EPS growth of 4.2% in the nine quarters since 1Q12.
We see a reasonably high risk that the market will sell off in response to on-consensus earnings. A significant portion of investors, both institutional and retail, feel that a correction of at least mid single-digits is overdue. If cumulative 2Q14 EPS growth comes in anywhere below 8%, we would expect some selling.
Jim Kelleher, CFA, Argus Director of Research
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.