Dow Jones Industrial Average Is Rallying Despite Cuts In Forward EPS Estimates

Sep. 3.12 | About: SPDR Dow (DIA)

At the end of July, we first looked at how 2Q earnings were impacting forward EPS estimates of companies in the Dow Jones Industrial Average (NYSEARCA:DIA) (here). Now that the earnings cycle is complete we are updating our analysis. Interestingly, since the beginning of 2Q 2012 earnings season, there has been a divergence between the price action of the Dow Jones Industrial Average and the forward EPS estimates of companies in the index. The Dow Jones Industrial Average is up 2.5% since the release of Alcoa's (NYSE:AA) 2Q results on July 9, but the median EPS estimate for the September quarter is down -3%. The EPS estimates for the following quarter and next year are also down over this period. The Dow Jones Industrial Average's ability to rally with a backdrop of bad news, in terms of EPS estimates, seems like a positive for the market. Stock prices seem to have already priced-in the expected EPS weakness, and there are now other catalysts driving the market higher. In the article below, we take a closer look at the forward EPS estimates as well as the valuations of the components in the Dow Jones Industrial Average.

Background

The 2Q 2012 earnings season was generally perceived to be weak as expectations for many companies were significantly cut in advance and top line growth was soft. However, results were not a disaster and came in pretty much in-line with the reduced expectations.

Investors seemed content with these results. The Dow Jones Industrial Average experienced correction earlier in the summer following 1Q 2012 earnings season when investors adjusted lower their growth prospects for the year. Although 2Q 2012 earnings results were not impressive, they did not force investors to ratchet down their expectations further, and the lack of further bad news was the catalyst for the ensuing rally.

(click to enlarge)Click to enlarge

(Source: FreeStockCharts.com)

EPS Growth Outlook For The Components Of The Dow Jones Industrial Average

Estimates from sell side analysts seem to be projecting weak EPS growth in the short term, but an improvement in 2013. Although EPS estimates have been reduced across all timeframes, it remains to be seen if analysts are still too optimistic about the 2013 results. As the year rolls on, analysts and investors will soon shift their focus to 2013, and it will be interesting to see if the current estimates hold up.

For the upcoming quarter ending in September (or corresponding periods for companies on different reporting cycles, see notes below), analysts are expecting only 50% of companies to report EPS growth compared to the prior year's period.

Analysts are more optimistic about the December quarter (or corresponding period, see notes below) and estimate that 76% of companies will report EPS growth.

The real optimism is left for FY 2013 (or the corresponding period, see notes below). In FY 2013, 90% of companies in the Dow Jones Industrial Average are expected to show EPS growth. Furthermore, the EPS growth rate is expected to be higher in FY 2013 than in FY 2012. In FY 2012, the mean and median EPS growth rate for companies in Dow Jones Industrial Average is expected to be 6% and 5%, respectively. However, in FY 2013, the mean and median EPS growth rate is expected to be 15% and 9%, respectively.

(Source: Soha Group Blog, Dow Earnings Center; data from Yahoo Finance; see further notes at end of this article)

In the next sections, we present a more detailed look at the forward EPS revisions.

Revisions To EPS Estimates For The September And December Quarters

Since the beginning of July, EPS estimates for the September quarter were revised down for 59% of the companies in the Dow Jones Industrial Average and the median change was -3%.

(Source: Soha Group Blog, Dow Earnings Center; data from Yahoo Finance; see further notes at end of this article)

Revisions To EPS Estimates For FY 2013 (Or Corresponding Reporting Period)

The story for FY 2013 (or FY 2014 for companies on a June reporting cycle) is similar. EPS estimates were cut for 66% of the companies in the Dow Jones Industrial Average and the median decrease was -1%.

(Source: Soha Group Blog, Dow Earnings Center; data from Yahoo Finance; see further notes at end of this article)

Valuation

It is hard to argue that the companies in the Dow Jones Industrial Average look expensive. Although some have problems and may experience earnings pressure, the P/E valuations generally look reasonable and may be cheap in some cases. The mean and median P/E for FY 2012 are ~13.5x and the mean and median P/E for FY 2013 are 11.8x. (Please note that the Dow Jones Industrial Average is a price weighed index, but these figures assume an equal weighting of all companies).

The valuations may seem reasonable, but in order for them to act as a catalyst to bring in new investors, the earnings component needs to be sustained. Considering the projected year-over-year EPS declines in the September quarter, it is understandable that investors are questioning the sustainability of earnings and not pushing up stock prices to higher levels. But, if the pessimism is overdone and the earnings environment improves in 2013, then the current valuation levels may be attractive.

(Source: Soha Group Blog, Dow Earnings Center; data from Yahoo Finance; see further notes at end of this article)

Conclusions

Since July, the Dow Jones Industrial Average has been moving up despite much bad news in corporate earnings. The bad news consisted of weak 2Q earnings for many companies and reductions in forward EPS estimates. However, the divergence between the price action and downward EPS revisions could be seen as a bullish sign. Maybe, all this bad news was priced in and investors are now anticipating a more positive outcome.

This optimism may be reflected in the EPS estimates for FY 2013 that call for a rebound in growth. However, it is unclear if analysts have fully marked down their FY 2013 estimates to match the current sentiment.

Considering that bad news is not driving stocks lower, low valuations may be acting as catalysts to move stock prices higher. We believe that the market is pricing in a lot of pessimism and prefer to take advantage of the reasonable, or low, valuations to increase our exposure to equities. We base our investment decisions on a number of factors, but we think that these trends are being overlooked.

Notes

Please see our Soha Group Blog, Dow Earnings Center for the backup data for the charts presented in this article.

* All companies in this section report on a December fiscal year cycle, except HD and WMT that are on a January fiscal year reporting cycle.

** All companies in this section report on a June fiscal year cycle, except CSCO which is on a July fiscal year reporting cycle.

*** All companies in this section report on a September fiscal year cycle, except HPQ which is on an October fiscal year reporting cycle.

Disclosure: I am long BAC, DIS, WMT, JPM, XOM, PG, IBM, CAT, PFE. 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.

Additional disclosure: We may trade any of the stocks/ETFs mentions in this article in the next 72 hours or at any other time.