Stock prices always reflect future earnings prospects, so the reason the market has rolled over is not just because of arcane technical forces but because growth has slowed to a crawl.
We’re two weeks from the start of third-quarter earnings season, so let’s take a look at what we’re facing.
At the moment, estimates for Q3 earnings growth rests at -1.6%. Just five months ago, on April st1, the estimates growth rate for the third quarter was 17.3%! On July 1st, growth expectations fell to 12.6%, so you can see that an evaporation of hope has led to a rough market.
According to ThomsonReuters, if the final growth rate for the third quarter less than 1.6%, it will mark the first time since the 2001-2002 recession that the market had experienced five straight quarters of negative earnings growth.
Of course, expectations for growth in the financial stocks has been hit the hardest. The mean estimate for Lehman Brothers (LEH) sank to -$5.46 per share this week from -$2.49 last week, which is what led to the stock’s plunge in value. Overall, ThomsonReuters says that the growth rate of financial companies dropped to -59% from -54% in the past week. (See also: "You Can Make Money on the Failing Financials.")
On a dollar basis, the net income for all investment banks and brokerages is expected to be -$11.7 billion in the quarter, while diversified financial companies’ earnings will be -$3.4 billion. Expectations are down by more than $10 billion since the quarter began in July, which tells you something about how overly optimistic analysts were just a few months ago—a time when many folks thought estimates were already too low.
As you might expect, energy companies are expected to have the highest earnings growth in the third quarter, at 59%. Their growth is so strong that if you take Energy out of the S&P 500, the growth rate for the remaining nine sectors of the index is -12.1%.
On the other hand, if you leave Energy in and take Financials out, then the growth rate for the remaining sectors is 13.6%.
And finally, just to take this exercise to an extreme, if you take out both Financials and Energy, then the growth rate of the remaining eight sectors would be 3.1%. (To learn more about how earnings can guide your investment strategy, check out: "How to Invest: Guided by Earnings.")
So who’s bringing up the rear besides banks and brokers?
That would be Consumer Discretionary, at -7% growth for the quarter. That follows on a four-quarter average earnings growth decline of -29%. The worst industry in the group is Auto Manufacturing, so if you remove them the growth rate for the rest of the sector would be 11%.
So far there have been 407 negative Q3 earnings-per-share pre-announcements by companies, compared to 153 positive pre-announcements. The ratio of negative to positive is thus 2.7, which is well above the ratio of 2.0 recorded with two weeks to go before second-quarter earnings.
While that sounds bad, it’s one of those funny "bad" numbers that is actually good. Research shows that the higher the negative/positive ratio before a quarter, the more likely that companies will beat their low expectations and that stocks will actually rise once earnings are announced. (See also: "Best Buy to the Rescue?" and "Recession Creates a Vicious Cycle.")
Okay, now here is the scary part… Expectations for the fourth quarter are completely out of whack.
At the moment, the estimates growth rate for Q4 stands at 54.7%, according to ThomsonReuters. The expectation was for 59.3% growth back on July 1st. Expectations for earnings growth is highest for energy and Materials sectors, at 37% and 30%, while Financials are expected to lose $33.5 billion in the quarter, vs. a loss of $20.4 billion in the same quarter last year.
When we crunch these numbers into an effort to determine the valuation of the market, we see that the forward four-quarter price/earnings ratio for the S&P 500 right now is 12.8. From a recent historical perspective, that is quite low. And since it is predicated on nearly 55% growth next quarter, it is more than likely too high—making the market even cheaper.
In summary, expectations for the third quarter have certainly started to reflect reality, and may even be too low—so it’s entirely possible that a lot of companies will beat their forecasts, and therefore have the opportunity to see stock prices appreciate. But expectations for the fourth quarter are almost certainly way too high, which is a mitigating factor and will work to keep prices down.
Overall, then, the tone of next quarter is setting up to be one where companies announce better-than-expected third-quarter numbers but then provide a sour forecast for the fourth quarter as well as for the first half of 2009. That is a recipe for a lot more volatility and not a lot of progress.
There is a way to make money in an environment like this, however. To learn how to profit amid peril, come check out Trader’s Advantage.
This article was written by Jon Markman, contributor to InvestorPlace Media. For more actionable insights like this, visit www.InvestorPlace.com.
