Second-Quarter Earnings Preview: Is The Bar Set Too Low?

by: Lou Basenese

Another earnings season is upon us!

Aluminum giant, Alcoa (NYSE:AA), officially got the ball rolling after the bell on Monday. And despite reporting year-over-year declines, the company beat expectations on the top and bottom line.

Revenue checked-in at $6.01 billion versus expectations of $5.81 billion. And adjusted earnings came in at $0.06 per share versus expectations of $0.05.

While I typically shun reading too much into a single company’s earnings report, Alcoa’s report does warrant our attention. Why? Because it highlights a trend I expect to see over and over and over again this earnings season: Companies beating expectations for revenue and earnings.

Why’s that? Well, because leading up to this earnings reporting season, analysts got incredibly bearish. Case in point: Over the last four weeks, analysts raised forecasts for 279 companies in the S&P 1500 Index. But they lowered forecasts for 717 companies, according to Bespoke Investment Group.

Heck, Alcoa is a poster child for the bearish trend. A FactSet survey shows the consensus analyst estimate for the company’s earnings was slashed 47% over the last month.

Clearly, analysts got too negative. I expect the same to hold true for most companies. In other words, the earnings bar is set way too low this quarter.

Given that the S&P 500 Index is already trading on the cheap – at about a 15% discount to its long-term price-to-earnings (P/E) ratio – the stage is set for a strong rally as companies report positive surprises.

With that in mind, here are the three metrics we should be focusing on as this earnings season unfolds.

~ Key Statistic #1: Earnings “Beat Rate”

No doubt, longtime readers tire of me saying this. But it’s a proven fact that stock prices ultimately follow earnings. As long as companies are producing more and more profits, stock prices are likely to charge higher.

To quickly gauge whether or not the stock market should head higher based on earnings, all we have to do is monitor the earnings “beat rate” – the percentage of companies beating analysts’ expectations for profits.

You’ll recall that first-quarter earnings season started off with a bang, with over 70% of the companies beating expectations. But it went out with a whimper. Of the 2,257 companies that reported earnings, only 59.5% ended up beating expectations.

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Given the extremely low bar set by analysts this quarter, we’ll need an earnings beat rate of 65% or more to move stock prices noticeably higher.

~ Key Statistic #2: Revenue “Beat Rate”

As the temperature outside ticks higher, talk about a U.S. recession is also on the rise, just like in 2010 and 2011. In a future column, I’ll share why those fears are completely overblown. For now, let’s just agree that the surest way to squelch those fears is for companies to report better-than-expected sales figures.

Sales can’t be faked. So they represent the clearest sign that demand for goods and services are increasing – or at least hanging tight – in the face of a European slowdown.

Here, too, we don’t need to worry about reviewing every last company report. We just need to track the revenue “beat rate” – the percentage of companies beating analysts’ expectations for sales.

Like the earnings beat rate, the revenue beat rate also started out strong last quarter, but tapered off to end at 62.7%.

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This quarter, a reading north of 65% should prove to be another catalyst for higher stock prices.

~ Key Statistic #3: Guidance Spread

Since the stock market is a forward-looking beast, past results don’t matter as much as expectations for the future. And, obviously, the market could use a healthy dose of optimism right now.

The easy way to get a pulse on expectations for the future is to track the guidance spread. That is, the difference between the percentage of companies raising guidance and the percentage of companies lowering guidance.

A positive spread indicates that more companies are optimistic about the future. And a negative spread indicates that more companies are pessimistic.

As a frame of reference, the guidance spread has been negative for the last three quarters.

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The end result? Any type of positive reading this quarter will go a long way to push stock prices higher.

Bottom line: The 3.3% drop for the S&P 500 Index in the second quarter reveals that investors have already priced in the worst news. Couple that with analysts’ extreme bearishness, and the stage is set for a stock market rally. Just like I predicted last week.