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Can Stocks Survive The Earnings Slowdown?

Daily State of the Markets
Friday, October 19, 2012

Publishing Note: I am traveling on Monday morning and will not publish a report. Daily State of the Markets reports will return on Tuesday.

Good morning. About the time the lunch hour rolled around on Thursday, stocks were surging and it looked like the bulls were going to run away with the game. After a shaky start, it appeared that the buyers had returned, the stops were being hunted, and performance anxiety was back in vogue. It was also interesting to note that the S&P was very close to breaking out of the current trading range to the upside. And at this point in the year, a breakout to higher ground would likely lead to an awful lot of fund managers hopping on the bull bandwagon in an attempt to catch the traditional year-end rally.

However, a funny thing happened on the way to the party - stocks got Googled. A botched report issuance and a big miss from the technology leader allowed the bears to get up off the mat. Then after Microsoft's report stunk up the joint after the close, the question of the day now appears to be not "How high can we go?" but rather, "Can the market survive the earnings slowdown?"

To be sure, everyone in the game knows that Q3 earnings were not going to be a bowl of cherries. Analyst expectations for the quarter have been coming down since the middle of summer. The quarter that was estimated to sport a growth rate of nearly 2% as of June 30th is now expected to show a decline of 2.5% or so. Thus, the fact that the earnings reports we've seen so far haven't been stellar isn't really much of a surprise.

However, the problem here is three-fold. First, with analysts having whittled down the estimates for Q3 and companies having had ample time to "guide the quarter lower," (a strategy that Google apparently isn't familiar with) the bulls had been hoping that the earnings bar had been lowered sufficiently so that companies could easily exceed the expectations. And yet any number of big name companies has missed the new, lower estimates. And what's worse, the trend from last quarter of companies continuing to miss the revenue targets appears to be continuing unabated. So, unless the earnings parade can turn itself around and companies can start hurdling the lower expectation bars, the bears tell us that stocks could be in trouble.

The second problem is that Q4 earnings estimates have not yet faced the hatchet. As things stand right now, the expectations for EPS to grow by double digits in Q4 are simply too optimistic. As such, we should probably expect to see a lot more downside revisions and lowered guidance on the earnings front for a while.

The third and perhaps biggest problem as it relates to the earnings of companies like Intel (NASDAQ:INTC), IBM (NYSE:IBM), Google (NASDAQ:GOOG), Microsoft (NASDAQ:MSFT), and Chipotle (NYSE:CMG), is most investors believe that the quarterly downturn in the growth rate of earnings means there is going to be a lot more quarters of negative growth to come.

For what I'm about to discuss to make sense, we've got to remember that once you strip away all the intraday HFT and algo-driven crap that occurs on a daily basis, the stock market is effectively a discounting mechanism for future expectations. And history shows that a quarterly slowdown in earnings growth doesn't always lead to further declines in earnings. Remember, this game is about the expectations for what is going to happen next.

If we look back at history, the S&P 500 has seen negative earnings growth during a single quarter on seven different occasions. In looking at the data, the question I had was how many times in the past did that first quarter of negative earnings growth lead to a trend of declining earnings growth. Unfortunately, our statistical sample only contains seven inputs. But the good news is that one cockroach sighting, if you will, didn't always lead to more.

If you combine the earnings data with the economic cycles seen over the past 25 years, it becomes clear that the key to future earnings not going into the tank has to do with the state of the economy. History shows that in the past, if an economy had been weak enough (such as the slowdown we've seen this year) to produce negative earnings growth for the S&P 500, it was the question of whether or not the country went into a recession that held the key to future earnings growth. If a recession occurred, then, not surprisingly, earnings continued to tank. But if the economy recovered, then so too did earnings growth.

My point here is that we shouldn't be looking at current earnings to predict the future of the stock indices. In other words, just because earnings are not great this quarter doesn't mean that stock prices will go down. Again, this game is about future expectations. And it is also important to recognize that stock prices tend to lead the economy (as they discount the expectations of what will come next) and not the other way around.

So, can the stock market survive an earnings slowdown? You betcha - as long as investors can expect the economy to improve in the future. And THAT is the key to the market over the coming months. Thus, we will need to keep a close eye on Congress and the Fiscal Cliff after the election. You see, if the Fiscal Cliff is not dealt with - and fast - the economy will likely enter a brief and largely technical recession. However, stocks may not like the view of the future if Congress continues to play their childish partisan games.

Turning to this morning... The earnings parade is in focus this morning as Microsoft, GE, and just now McDonald's have all produced results since yesterday's close suggesting that they are struggling a bit in this economic entironment. In addition, European markets are weak this morning. As a result, it is not surprising to see futures pointing to a lower open on this options expiration Friday.

On the Economic front... We'll get the report on Existing Home Sales this morning.

Thought for the day... Good, better, best. Never let it rest. Until your good is better and your better is best. -Tim Duncan

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

  • Major Foreign Markets:
    • Shanghai: -0.17%
    • Hong Kong: +0.15%
    • Japan: +0.22%
    • France: -0.57%
    • Germany: -0.51%
    • Italy: -1.51%
    • Spain: -1.55%
    • London: -0.20%
  • Crude Oil Futures: +$0.22 to $92.32
  • Gold: -$8.90 to $1735.80
  • Dollar: lower against the pound, higher vs yen and euro
  • 10-Year Bond Yield: Currently trading at 1.808%
  • Stock Futures Ahead of Open in U.S. (relative to fair value):
    • S&P 500: -4.09
    • Dow Jones Industrial Average: -24
    • NASDAQ Composite: -12.02

Positions in stocks mentioned: none

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