Q1 Earnings Will Blow Past Expectations

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Includes: DIA, IBM, IWM, QQQ, SPY
by: Martin Vlcek

Summary

Almost everybody is extremely bearish about Q1 earnings expectations.

Due to several factors described, I believe Q1 earnings will surprise to the upside.

Therefore, after this pullback, there is a high risk that markets will shock investors by breaking out to the upside on positive Q1 earnings surprises.

In the long run, I remain more cautious on the market outlook.

Everybody and their Uber driver are bearish on the upcoming earnings season and skeptical of the recent stock market rebound. For Q1 2016, the currently estimated earnings decline is -8.4% year-over-year. FactSet notes that:

"If the index reports a decline in earnings for Q1, it will mark the first time the index has seen four consecutive quarters of year-over-year declines since 2008/2009."

Here is my contrarian near-term outlook which I would like to support in the article: I believe these extremely bearish Q1 earnings expectations, the low year-over-year comparisons and several factors described below, are setting us up for a massive breakout rally in the safe segment of the stock market that will painfully trap some bears in the upcoming weeks, once the current market pullback is finished.

By the "safe" segment of the market I mean low-debt stocks, blue-chip dividend-paying stocks, bond-like stocks. These are mostly found in the Dow Jones Industrial Average (NYSEARCA:DIA) and to a slightly lesser extent in the S&P 500 (NYSEARCA:SPY). I also believe stocks sensitive to the U.S. dollar will do well. I am less optimistic about many Nasdaq (NASDAQ:QQQ) stocks and especially Russell 2000 (NYSEARCA:IWM) names, many of which have unattractive valuations, high-debt levels and many are unprofitable. Their recent stock price rises have been perhaps driven more by a short squeeze than by new voluntary buying.

In the longer run, I am more cautious due tomany factors I will leave for future articles.

The dollar effect on Q1 earnings

The U.S. dollar has been appreciating massively over the past two years, as much as 30% against many trading partners' currencies. However, the U.S. dollar finished its rapid descent (at least the current leg) in a volatile move in March 2015:

Source: Stockcharts.com, author graphics

So, Q1 2016 will be the first quarter when the U.S. dollar did not appreciate, on average, and will even weaken by roughly 5% Y/Y (!) if measured by the exchange rate on the last day of the quarter, provided that the dollar remains where it is now, until the end of March, of course. I believe this will be a shock to many market participants when they realize the dollar is again a tailwind to many S&P names. Unfortunately, the markets seem to have already discounted some of the dollar effect (and reflation or inflation).

For example, IBM (NYSE:IBM), a stock I called a cheap hedge against a weaker dollar three months ago, is up ~25% from its February low, whereas the broad market is up "just" ~12%. More than half of IBM's sales are derived in non-U.S. currency.

To sum up the U.S. dollar effect on Q1 earnings, I think many investors will be shocked by the solid numbers posted by the S&P companies exposed to the foreign currency effects. The last year's headwind will flip to a tailwind. Provided that roughly 50% of the S&P profits come from non-U.S. currency, I estimate the effect to be roughly 2.5% positive contribution to the year-over-year numbers if expectations were for a flat USD exchange rate. Given many companies expected a negative effect three months ago when reporting their outlook, the positive surprise may be even higher.

Of course, many companies hedge some or all of the currency exposure, but the companies that sold off on the strong dollar woes should regain a good portion of their lost ground, unless the markets expect further dollar strengthening, which is entirely possible.

The oil effect

Due to the significant fall in oil stock prices, this segment now represents an unusually small share of the S&P 500 weight. And, while the riskier portion of this segment will probably keep losing value, as they slowly but surely descent into the inevitable debt restructuring or a bankruptcy, the high quality of the market, those companies that are very likely to survive this, will likely surprise to the upside.

Oil futures contango and hedging blur fog the oil and gas earnings picture somewhat. But overall, the year-over-year trend is still very negative, although the rate of change will likely decelerate going forward. Provided that we've seen the oil price bottom in February 2016, it will take a full year to see decisively positive year-over-year oil trends.

Source: Stockcharts.com, author graphics

But, there is a big but. Sure, Q2 will be a very tough comparison as prices hovered around $60 per barrel last year. However, Q3 could see an interesting development as prices last year were around $40 to $50. So, Q3 could be the first quarter for which year-over-year price change would be positive or at least reasonably close to neutral. The strong companies also had time to adjust and we know markets are forward-looking. Perhaps this is what was partly behind the recent rally in oil, among other factors. Depending on the outcomes of OPEC's meetings (April, June/July?), we may be surprised by the strength in oil, or disappointed. So I expect volatility in oil prices.

To sum up my expectations for the oil effects on the S&P - the impact will be negligible. Oil prices are still negative for the year-over-year comparisons but the weight of the oil sector on the S&P is at most half of what it was a year ago, and it was relatively small then already. Of course, if the current oil rally reverts more, this could be an additional negative risk factor for the broad markets.

But, we are probably closer to the bottom than to the top of the long-term oil price range ($30 to $70 is my wild guess). So for the long run, it may be smart to buy high-quality oil and gas names during the next oil dip.

The leap year effect

I don't have any firm numbers, but I suspect most S&P 500 companies don't adjust quarterly earnings for the effect of the leap year day, February 29. This year, we had an extra "free" day in February, which can boost the numbers for the month by roughly 3% on the raw top-line numbers. For a company with stagnant sales, this can be a massive boost, albeit a temporary one. For the quarter, the positive sales effect will probably be closer to 1% or a bit more, nothing spectacular but still providing some support to the all-important, top-line growth which many companies have struggled with during this cycle.

The bottom-line effect can be even stronger due to some fixed costs (such as interest rates, rents, and much more) being the same, whether it is a leap year or not. I estimate the boost to the bottom line could reach as much as 2%. So if a company was expecting a positive 3% Y/Y EPS growth, the actual number would come at 5% this time, merely due to the leap year effect.

So the leap year factor will provide a tailwind, although shrewd investors will realize this is a one-off gain. Moreover, the effect will actually revert in a year from now because the comparison base will be relatively higher, potentially setting up for a negative surprise in Q1 2017, and for the entire 2017 vs. 2016.

This is an election year, and also the end of the 8-year election cycle

Almost every administration tries to boost the economy before the elections but there is also greater policy uncertainty. Markets, on average, tend to slightly fall or remain flat (and volatile) in the 8th year of the election cycle. We've seen lower oil prices - we may now be seeing a weaker U.S. dollar again and continued coordinated central bank easing (in terms of poker terminology, the ECB seemed to have been on the big blind in March, lowering rates and expanding the asset purchases). We are also likely to see increased government spending in order to make to economic indicators look as good as possible. This could support the stock market.

And, we have not even mentioned the tailwind provided by the corporations themselves through continued buybacks. Once their respective pre-earnings blackout period ends, they will be automatic buyers again.

The main risk: Forward EPS vs. stock prices

You can clearly see on the chart below, how the stock market has gotten ahead of itself, in terms of following the forward EPS line, similar to what happened in 2006 and 2007.

Click to enlarge

Source: FactSet

Yes, it is about the FED's end to QE and their first rate hike. But in the long run, stock prices are always driven by the forward EPS expectations and there is clearly a gap at the moment. Until this gap resolves (forward EPS rises or the index falls), the market is bound to be more volatile than we were used to when the index was below the forward EPS line.

There are at least three scenarios. First, the forward P/E can start rising and catch up with the stock prices, in which case the market can keep rising even if its P/E multiple remains at the current elevated level.

Second, the forward P/E may stagnate but the market can remain at the current level in a wait-and-see mode at the current P/E/ multiple, or the multiple can even expand if central banks induce more easing.

Third, the forward EPS falls or remains sluggish and the markets grow impatient and sell off to the 1,750-1,800 region, where the forward EPS"support" line rests.

So if my assumptions, for the current (and the next) quarter about positive earnings surprise, prove to be incorrect, we could see lots of volatility to the downside.

Conclusion

I hope we have a pullback between now and the true beginning of the Q1 earnings season reporting, because I believe any such pullback would offer an excellent opportunity to load up in the stocks from the"safe" and dollar-sensitive segment of the markets, as I defined in the article, mostly found in the Dow Jones Industrial Average and S&P 500 indexes. I believe Q1 earnings of many of these stocks will surprise to the upside and so will their stock prices, at least in the short term.

Because it is a big 8-year election year, because central banks continue easing and talk about more easing measures for the future if needed, because the year-over-year comparison will be so low, because the oil has stabilized and because the U.S. dollar is easing at the same time - I believe the shock for market participants this spring and summer will not be a downside but an upside breakout. This will be the case at least for the safer part of the market, the blue chips and net cash positive stocks with positive FCF.

I simply cannot imagine how this portion of the market, that trades more like corporate bonds and not stocks, could fall significantly given that more and more central banks are adding corporate bonds (how long before they start adding the stocks? BOJ already buys stock indexes). This naturally has to support prices of these stocks. On the other hand, the leveraged, indebted, loss-making, risky portion of the markets may see overall demand for them waning further.

My longer-term outlook for the overall market remains more cautious.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.