Can Second-Quarter Earnings Save The Stock Market?

| About: SPDR S&P (SPY)
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Summary

Corporate earnings declined in the first quarter of 2016, reflecting slow economic growth, lagging labor productivity gains, and low business investment.

Some are suggesting that second-quarter earnings might come in better than expected because of the very low results a year ago and some back-off in oil prices and dollar value.

The problem is that this sought-after optimism is very myopic and avoids the longer-run issues that will continue to impact corporate profits over time.

The stock market in the United States is near all-time historical highs. But there are lots of issues on the table that hold out threats to these highs.

One of these issues is the state of the economy. With economic growth coming in around 2.0 percent year over year, and with not much hope for it to rise much in the near future, there is real concern that corporations will not be able to produce the results that would sustain such a high level for stock prices.

One measure that contributes to this concern is Bob Shiller's Cyclically Adjusted Price Earnings (CAPE) ratio, which, in June, is around the highs it reached since the 2001 economic recession. Using this measure, stock prices are very high relative to corporate earnings, producing a CAPE of 26.35.

Historically, CAPE eventually moves back toward its long-term mean. Thus, unless corporate earnings rise, the argument can be made that sometime the stock prices will move downward to bring the cyclically adjusted price earnings ratio back to a lower value, somewhere in the 18.00 to 19.00 range.

Justin Lahart in the Wall Street Journal suggests that we might get such a bounce in earnings in the second quarter. Mr. Lahart reports that after a very bad first quarter, when profits fell 5.0 percent from a year earlier, Thomson Reuters, indicates that economists believe that corporate earnings will fall by 3.5 percent in the second quarter year over year.

However, Mr. Lahart suggests that there is a hitch in these expectations. These forecasts, he argues, are "pro forma" estimates "that exclude certain items, such as restructuring charges." The estimates, in other words, do not conform to generally accepted accounting principles, or GAAP.

Mr. Lahart suggests that GAAP earnings "will likely be much higher than they were a year earlier." His argument:

"In the second quarter of last year S&P and Dow Jones Indices figures show that GAAP earnings were 24 percent lower than pro forma earnings. With this gap unlikely to be nearly as wide in the second quarter this year, GAAP earnings probably grew strongly."

But Mr. Lahart goes on even further:

"Even on a pro forma basis, earnings may come in a lot better than where estimates stand. Fewer companies have warned on second quarter results than they had at the same point in recent quarters-historically, a good indication. Estimates haven't fallen as sharply as usual through the quarter, which also bodes well.

Moreover, neither the decline in oil prices nor the strength in the dollar will weigh on earnings like they have in recent quarters."

He further suggests, "when profits start coming out of the trough, it is often a good time to buy stocks." So, if you are looking for a positive sign to buy stocks, here it is.

The question is… is this really a good time to buy stocks? For one, Mr. Lahart is focusing just on the results of one quarter. His argument is based on a "statistical gap" that occurred one year ago and is not likely to occur again, at least not to the extent it existed last year.

So, we have a "fluke" in the data that is unlikely to be repeated. This is one reason that the economist Shiller "adjusts" the data to smooth out one quarter movements like these. But Mr. Lahart also states that corporations have not given us any early signals that things might be worse than expected and this is good news.

And with oil prices rebounding somewhat and with the US dollar weaker, these factors may impact earnings less than in recent times. In other words, we have a series of reasons why the performance of corporate earnings may be better in the second quarter than they were in the first.

Again, however, these "hopes" are just based on one-time things and not on the underlying economics of the situation, let alone all the political factors that could impact how the world is evolving. This optimism does not seem to take into consideration the fundamentals of the situation and therefore argues for maybe some short-run volatility in the market based on accounting swing one-time events.

Unless one is a very short-term trader, it would seem that the reasons given here for an improvement in corporate earnings in the second quarter versus the results from the first quarter are just an effort to present an optimistic scenario within an environment that is not so optimistic.

If Mr. Lahart is correct in his suggestions about how second-quarter earnings might turn out, I could very well see an earnings season where second-quarter earnings rebound from the not-so-good first-quarter results, but where stock market prices remain roughly around current levels.

What is important is the longer-run view, the one that takes into account the slow growth of the economy, the lag in the improvement of labor market productivity and the reluctance of businesses to spend money on real capital expenditures.

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.