The second-quarter earnings season will kick off in earnest on Friday with the first reports from big banks, and investors should brace for what will be a key test of sentiment.
The stock market is at lofty levels after repeatedly setting records this year, and companies need to show earnings growth to justify those levels. Even the Federal Reserve has pointed out that stock valuations are above historical norms, a view that was repeated this week by Chairwoman Janet Yellen in testimony to the House Financial Services panel.
The FactSet blended year-over-year per-share earnings growth rate estimate for the S&P 500 which combines results for those companies that have reported (companies with a fiscal quarter that ended in May) with those still to come, stood at 6.3% on Wednesday. That’s below the 13.8% rate recorded for the first quarter, which enjoyed the easiest comparison of any period this year.
That’s because the first quarter of 2016 marked the trough of the earnings recession, the long stretch of earnings declines that started in the third quarter of 2015. Analysts expect the second-quarter rate to improve as the earnings season gains pace and revisions move up. But the question for investors, is whether earnings valuations will improve enough to support the S&P 500 index’s
rapid rise this year toward record levels.
See also: Earnings recession is over, but it’s not enough to support stock market’s gains
“We believe another quarter of double-digit earnings growth for the S&P 500 in the second quarter is possible, given generally solid overall economic data, the strong rebound in energy sector profits, and solid financial and technology sector earnings gains,” said Burt White, chief investment officer for LPL Financial. “Earnings estimates have been resilient and the ratio of positive to negative pre-announcements is as positive as it has been in three years.”
Still, there are headwinds, including the strong dollar, a regular bugbear for companies that generate a lot of revenue overseas, and lower inflation, which gives companies less pricing power. There is also the uncertainty surrounding many of President Donald Trump administration’s promised policy moves, notably on health care and tax reform. Efforts to overhaul or replace the Affordable Care Act remain bogged down with Republicans unable to reach agreement among themselves. Tax reform is not expected until the details of a health care plan are known.
White said he’ll try to evaluate just how much a policy boost is baked into analyst expectations this earnings season. He expects it is minimal, and is skeptical of any major initiatives happening in 2017, although tax reform, if it were passed, would be a strong boost for the S&P 500.
The energy sector is expected to lead second-quarter gains, mostly because it is recovering from a very low base. In the more than two years that oil futures prices have drifted lower and lower, companies have slashed capex budgets, sold assets and made other moves to get back to growth in a low oil-price environment.
The tech sector is expected to be second-strongest, driven by chip makers, which are enjoying strong demand — and stock price gains — thanks to the self-driving trend, the popularity of videogaming and the rise of artificial intelligence.
But the entire consumer discretionary sector is expected to be a weak spot, given the severe stress in the retail sector as Amazon.com Inc.
devours everything in its path. Health care is another troubled sector, given the uncertainty about the future of the ACA.
The consumer discretionary and utilities S&P 500 subsectors are expected to report declines in earnings.
One issue MarketWatch is watching for this earnings season is any comment on a new revenue-recognition accounting rule that will go into effect on January 1, 2018. The rule, named ASC 606, aims to create consistency between how revenue is recognized under U.S. Generally Accepted Accounting Principles, or GAAP, and International Financial Reporting Standards. It’s expected to change the timing of the recognition of some revenue and may impact the gross amount of revenue presented for certain customer contracts. It will have an impact on every sector, including banks.
Read: Banks are beginning to admit a new rule on revenue recognition will have an impact
Some companies have already talked about their preparations for the change, which could have a major impact on revenue.
Here are four key sectors to watch this quarter:
Energy will rebound, but outlook is unclear
The energy sector is expected to post earnings growth of 387% for the quarter, and sales growth of 17%, according to FactSet, as it rebounds from the crushing losses of the past two years. But results will be uneven across the various segments of the market with the major integrated oil companies and refiners expected to enjoy the biggest gains and results from oilfield services companies expected to be more subdued.
The outlook for the rest of the year is less certain, as oil futures prices have not performed as expected so far. 2017 was supposed to be another year of recovery, and it started with most experts cautiously optimistic about global oil markets on hopes that an improving global economy, more demand and a slowdown in production growth would result in higher prices and diminishing stockpiles.
“Some of these elements have played out as expected, some have not,” analysts at Simmons said in a recent note. Global inventories are above a five-year average and higher than what they were at the end of last year, and thus “oil prices and energy stocks have unraveled,” they said.
The average daily price of crude oil futures
during the quarter was $48.18 a barrel, according to an analysis of data provided by FactSet. That was up from the average price of $45.73 a barrel in the same quarter a year ago, but down from the 2016 closing price of $53.72 a barrel and from the first-quarter average of $51.83 a barrel.
Oil futures prices remain under pressure, trading under $50 a barrel in recent weeks. Although this week a higher-than-expected drop in U.S. inventories and news Saudi Arabia has cut its oil exports have pushed prices higher, crude futures have amassed monthly losses for every month of the year but February.
The effect of falling oil prices on the stock prices of energy companies is clear, as the correlation between crude futures prices and the SPDR Energy Select Sector exchange-traded fund’s
price over the past two years has been very high at 0.8906, according to FactSet data. A correlation of 1.0000 would mean they move identically.
Analysts at Barclays downgraded their view on oilfield services companies this week to neutral, keeping only Weatherford International Ltd.
and Halliburton Co.
as their equivalent of buy. “There simply isn’t much to do in North American oilfield services stocks,” they said in a note.
The Barclays analysts were less gloomy on prospects for major integrated oil companies, saying that despite the global imbalances in output and consumption they remain more positive in the 12- to 18-month outlook.
Refiners enjoyed a “relatively clean” operating quarter following heavy industry downtime in the first quarter, and markets “will begin to factor in next year’s earnings in their valuation models over the next 3-4 months,” they said.
Earlier this week, Barclays analysts upgraded Exxon Mobil Corp. shares
to their equivalent of buy from neutral, citing the stock’s recent underperformance and the company’s natural gas and petrochemical businesses.
Analysts at Tudor Pickering Holt said recently they expect a decline of 27% in net income for integrated energy companies, quarter on quarter, but improvements in cash flow.
“The current (low crude-oil price) environment isn’t prompting any further change in behavior in the integrateds, in our view because the companies can organically fund (capital expenditures) and dividends” at prices around $45 a barrel, they said.
The energy ETF
has tumbled 13.6% year to date through Wednesday afternoon, while the S&P 500 index
has rallied 9.1%.
The FAANG factor
Tech has been the most important driver for Wall Street since the end of the Great Recession, but its dominance is in question after a sudden downturn in technology stocks last month. This quarter’s earnings reports appear ready to determine if these stocks deserve their high prices, which could create the most important earnings season for Silicon Valley since the dot-com bust.
Projections show expectations for year-over-year earnings gains of more than 10%, and sales gains of 12% in the information technology sector. The most prominent stocks belong to the so-called FAANG grouping: Facebook Inc.
and Alphabet Inc.’s Google
Netflix kicks off the tech earnings season on Monday with its report, with all but Apple, due Aug. 1, lined up for the next week.
Facebook and Alphabet both face their second quarters reporting with a focus on GAAP metrics, which Goldman Sachs points out will have an effect on their gross margins, as well as the margins of tech as a whole. The second calendar quarter is historically Apple’s weakest, and the world’s most valuable company has admitted that consumers seem to be avoiding purchases of its biggest money maker, the iPhone, as they await a new version expected to launch late this quarter, as long as Apple can get past rumored issues with production.
With Amazon, the focus will be on its big play for Whole Foods Market Inc.
especially since its recent Prime Day promotion won’t factor in to the quarter being reported.
Those large tech companies may determine the eventual outcome of tech’s earnings season due to their large weights in indexes and prominence for investors and the general public, but the sector will also be swayed by less-known companies. Semiconductors will be especially important this quarter, as chip companies sell their wares to the larger players to power gadgets being produced for the back-to-school and holiday shopping seasons.
The push for artificial intelligence has made Nvidia Corp.
and Advanced Micro Devices Inc.
two of the most well-known tech companies for investors, with both stocks tripling in less than a year during volatile trading in the past few months. Both Nvidia and AMD launched new products in the quarter with eyes on the data center market, and market leader Intel Corp.
showed off its own new server offerings just this week in an attempt to beat back the competition. Investors will be looking for early returns on these new products, and hoping to hear more on the potential for future gains.
The reports scheduled for the next few weeks will be important in determining which investor was right: The one that has bet long on these companies producing the technology that will produce huge financial returns for years to come, or the ones who took their profits and walked away last month. The record highs for Wall Street indexes rest on the outcome.
Banking on financials
The financial sector is expected to show earnings-per-share growth of 5.5% over a year ago, according to FactSet, which currently puts it in third place among the 11 S&P 500 sectors, behind energy and information technology. But the EPS growth estimate fell sharply during the quarter, from a consensus of 8.6% growth as of March 31.
Investors should keep in mind that the year-over-year growth in EPS can be somewhat misleading. Banks have been aggressively buying back their own shares, because of “limited opportunities to allocate capital to value generating investments,” analyst Saul Martinez at UBS wrote in a recent note to clients.. “In fact, a substantial portion of EPS growth is currently driven by share buybacks, not earnings growth.”
Of the banks reporting on Friday, EPS grew 22% for J.P. Morgan Chase & Co.
in the first quarter, while outstanding shares fell 2.8%; Citigroup Inc.’s
EPS increased 23% in the first quarter, while shares outstanding fell 6.2%; and Wells Fargo & Co.’s
EPS rose 1% while shares outstanding decreased 1.3%.
“Ultimately, though, we question whether good EPS growth can be sustained once capital is optimized and rates normalize,” Martinez said.
Bank investors had good reason to cheer the results of the most recent Federal Reserve stress tests, but analysts are less upbeat about earnings.
“We see more misses than beats,” wrote Jefferies analysts in a July 5 note. J.P. Morgan analysts agreed, writing last week “We expect moderate 2Q earnings.”
Chris Whalen, a longtime bank analyst, expects earnings to come in soft enough that the stocks will trade off. “There’s no real growth on the top line,” he told MarketWatch. After several lean years, banks have run out of expenses to cut to boost the bottom line.
And most investors are finally starting to acknowledge that the hoped-for “reflation trade” isn’t coming, Whalen said. “The Trump Bump is dead.”
Read now: Bank earnings: Expect a weak quarter as hopes for a “Trump Bump” fizzle
The retail wreck
Retail is expected to be by far the weakest sector this earnings season. FactSet is expecting the consumer discretionary sector to show a decline of 2.2% in earnings, but a rise of 3.9% in sales.
Retail has moved into the troubled position occupied by the oil and gas industries last year, with distressed companies dotting the sector, bankruptcies pushing up the U.S. retail loan default rate and retailers and brands struggling to generate sales while feeling the “Amazon effect.” But where the energy sector was reacting to the oil price, retail’s problem is a secular shift that will change the retail landscape.
The SPDR S&P Retail exchange-traded fund
has fallen 9.0% over the past year, while the S&P 500 has climbed 13.7%.
“Three things characterize the current transformation,” Deborah Weinswig, managing director at Fung Global Retail and Technology, wrote in the group’s latest report. “Traditional retailers such as department stores and specialty retailers are undergoing huge disruption, emerging players in different segments are intensifying competition and higher e-commerce penetration is challenging brick-and-mortar retailers.”
As of mid-June, chain retailers have announced 5,321 store closings, a 218% increase from 2016, according to data provided by Fung Global Retail and Technology. Ten major retailers have filed for bankruptcy, more than all of last year.
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The industry is trying to get a handle on what the problems are, but finding solutions is proving to be a massive undertaking. Amazon is only getting bigger with the company planting its flag in the grocery sector with the recent bid for Whole Foods.
See also: On Amazon Prime Day, here’s yet another thing e-commerce is killing
Read also: Amazon ‘will be a top 5 grocer in the U.S.’ with Whole Foods acquisition
The reasons not to visit a bricks-and-mortar store have added up: stores aren’t compelling,shoppers don’t like fitting rooms, and low prices can easily be found online. Even parking is an issue, with 40% of drivers saying they avoid going to shops because of the challenges of finding a space, according to data provided by Inrix, a company that provides connected car services and transportation analytics.
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Retailers are taking steps to grow their business, outlining strategies like Runway 2020 at Michael Kors Holdings Ltd.
where selling more items at full price and speeding innovation are priorities. Or, like Nike Inc.
they are getting closer to the shopper, with more direct-to-consumer initiatives.
Read: In Nike-Amazon partnership, Amazon’s scale could put Nike at risk
Investors can expect an update on the continuing efforts to right-size retail footprints, get merchandise that customers want to them quickly, and improve operations across both stores and online platforms.
And perhaps, most important, investors and analysts will be looking for ways that companies are setting themselves apart from Amazon, creating a moat the e-commerce giant can’t cross. Experts say that Costco Wholesale Corp.
has done that effectively. And Instinet, in a June 26 note, highlights Ulta Beauty Inc.
which encourages trying new brands; off-price retailers like TJX Cos.’
T.J. Maxx or Ross Stores Inc.
that offer a “treasure hunt” shopping experience; and jewelers like Tiffany & Co.
and Signet Jewelers Inc.
which “has proven to be a very difficult category to drive online.”
A survey by JDA Software Group, a supply chain planning and execution company, found that half of respondents had bought an item online an picked it up in-store over the past year. And nearly one in three shoppers has bought something online and returned it in store in that time period.
“By offering incentives to shoppers to use BOPIS, like discounting, retailers are driving more foot traffic into stores, and potentially, buying more than they intended to, once they arrive at the store, boosting store sales,” said Jim Prewitt, vice president of retail industry strategy at JDA.
Additional reporting by Jeremy Owens, Claudia Assis, Tonya Garcia, Andrea Riquier and Francine McKenna
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