Corporate Profit Streak Is at Risk on Outlooks

Second-quarter earnings are coming in better than Wall Street forecasts — but then earnings always do, thanks to neither companies nor analysts sticking their necks out with overoptimistic estimates.

Of more concern is that revenue gains are weak even by recent lackluster standards, and outlooks are even worse. That’s putting Corporate America’s long streak of quarterly earnings growth in jeopardy — and possibly setting the market up for a pullback.

At the half-way point of earnings season, 71% of companies have exceeded Wall Street estimates, which is essentially in line with the average over the past four quarters, according to data from FactSet.

If nothing else, it shows that analysts took down their estimates by just the right amount to keep the positive “surprises” rolling in. As we noted at the start of earnings, the best thing that could be said of the season — maybe the only good thing that could be said — is that expectations were so low companies could trip over them.

The S&P 500’s blended earnings growth rate has come in slightly better than expected, too. Profits are up 3.3% rather than the 3% growth analysts’ forecast at the start of reporting season. Even after excluding Bank of America (NYSE:BAC), the blended growth rate for S&P 500 earnings dropped 1.5%, rather than the initial forecast for a 1.7% drop.

Credit big upside surprises from companies such as United Technologies (NYSE:UTX), Boeing (NYSE:BA) and Caterpillar (NYSE:CAT), among others, which helped offset misses from the likes of Apple (NASDAQ:AAPL) and Exxon Mobil (NYSE:XOM).

As for revenue, it’s been even worse than feared. Lower demand from Europe and China, coupled with a much stronger dollar, has taken a hatchet to top-line growth. S&P 500 sales have inched ahead just 1%, according to FactSet, down from a forecast for 3.4% growth at the start of the reporting season.

Furthermore, only 43% of companies have reported revenue ahead of Street forecasts, well below the trailing four-quarter average of 63%. If the current pace holds through the end of earnings season, it will mark the lowest revenue beat rate since the first quarter of 2009, FactSet says.

But most important, as always, are the outlooks — and they’re ugly.

A bloodbath of earnings warnings has the S&P 500 poised to post a year-over-year earnings decline of 1.6% in the third quarter. If the current reporting season remains on track, it will be the 11th consecutive quarter of profit growth — but that streak will end with third-quarter results.

That doesn’t bode well for the market. Stocks, after all, are forward-looking, and yet they have remained buoyant in face of sharply lower future earnings forecasts. See the chart from FactSet below:

Since early June, the estimated earnings growth rate for the S&P 500 (the blue line) has diverged sharply from the the S&P 500’s price level (the green line.) Indeed, the market has tacked on more than 50 points even as forward earnings estimates dropped to -1.6% from more than 3%.

Some of that is no doubt tied to anticipated central bank actions both in the U.S. and abroad. It also helps that the Street still sees fourth-quarter earnings growth of more than 11%.

But if another round of easing fails to come out of the Federal Reserve, policymakers once again fumble a response to Spain’s debt crisis or year-end profit forecasts deteriorate sharply, don’t be surprised if the market hits an air pocket.

It doesn’t appear that corporate profit growth, at least in the third quarter, will be providing much lift.

As of this writing, Dan Burrows held none of the securities mentioned here.

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