Get Ready: The Earnings Floor Is Set to Fall

Expectations of more monetary easing on the part of the Federal Reserve and perhaps a bold new bond-buying program in Europe sure look to be having a salutary effect on equities. Because whatever’s propping up the stock market these days, it sure isn’t the outlook for corporate profits.

Stocks have been on a five-week winning streak amid a slew of revenue weakness and — more important — a significantly lower outlook for future earnings. Since stock prices ultimately are driven by earnings, a dissonance is building between the market’s remarkable summer rally and a shorter-term future of contracting corporate income.

The S&P 500 is up more than 4% since Alcoa (NYSE:AA) unofficially kicked off the second-quarter earnings season back on July 9. The Dow Jones Industrial Average has added nearly 500 points during the same span, good for a gain of almost 4%.

Earnings season comes to an unofficial close Thursday when Wal-Mart (NYSE:WMT), the last Dow component to report, releases results. But for all intents and purposes, you can stick a fork in it — it’s done.

And it wasn’t all that pretty.

Yes, second-quarter earnings once again beat Wall Street forecasts — but then, they always do, thanks to neither companies nor analysts sticking their necks out with overoptimistic estimates.

With only about 50 companies in the S&P 500 left to report, 68% have exceeded analysts’ average estimate, according to data from Thomson Reuters. That’s higher than the long-term average of 62% and exactly matches the average beat rate of the last four quarters.

Furthermore, the S&P 500’s blended growth rate likewise came in ahead of estimates, increasing more than 8%. Even after stripping out financial stocks like Bank of America (NYSE:BAC), which had preposterously easy comparisons, the S&P 500 is eking out earnings growth of 1.3%.

That’s not a bad save, considering that heading into the season, profits were forecast to decline without the contribution from financials.

But here’s where it gets a bit scary.

The sluggish or downright recessionary global economy has clobbered demand. Combine that with a much stronger dollar, and you have the worst revenue picture in years.

The S&P 500’s second-quarter revenue increased just 1.1%, and only 41% of the constituent companies beat Wall Street estimates. For context, the long-term revenue beat rate stands at 62% and has averaged 68% over the trailing four quarters.

That’s wreaking havoc on corporate outlooks, and since stocks are forward-looking, in theory, stocks should be losing ground.

After all, the earnings warning bloodbath we pointed to earlier in the season hasn’t been stanched at all. For the third quarter, there have been 68 warnings versus 14 guidance hikes. That’s the worst ratio of bad news to good news since the third quarter of 2001, Thomson Reuters says.

Indeed, companies are now so cautious, earnings are forecast to decline decisively for the third (or current) quarter. As of June 30, Wall Street expected the S&P 500 to generate third-quarter earnings growth of 1.5%, according to data from FactSet. Cut to today, and profits are forecast to drop almost 3%. And yet the S&P 500 has added about 2.6% over the same period.

There’s no doubt about it: This is a weird market. Stocks usually move on some combination of fundamentals, technicals and headlines. For now, it seems, the fundamentals — at least for the current quarter — don’t matter.

As of this writing, Dan Burrows did not hold a position in any of the aforementioned securities.

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