Another quarter is coming to an end, and investors should start thinking about what is in store for the upcoming earnings season kicking off in October.
As most traders know, the results from the second quarter were nothing to brag about, and yet prices didn’t really suffer all that much. Should we expect the same next month?
Maybe not, but here are two key factors we think will matter most.
The All-Important Outlook
As you can see in the following chart, total corporate earnings in the U.S. have not exceeded their 2011 highs when adjusted for capital consumption and inventory values.
Stock prices as measured by the S&P 500, however, are up over 75% in that same timeframe. Some of this may be attributed to share buybacks, but that yield is still only a fraction of the returns.
What is surprising to many investors is that actual performance is not really a very good indicator for where a stock’s price will be following an earnings report. The outlook for future earnings are the key trend driver, which helps to explain why prices change continuously as that outlook shifts. The all-important question now is whether that outlook will shift as management attempts to set expectations for the end of the year.
This is the most important factor to consider during the upcoming earnings season. Low management expectations could finally end the rally as global economic conditions deteriorate.
There are a few S&P 500 components that report the month before the quarter ends (non-calendar fiscal quarters), and expectations have already been set moderately low. FedEx (FDX), Lennar (LEN), Kroger (KR) and Oracle (ORCL) have all released poor expectations for future profits this month.
Rate of Surprises vs. Disappointments
While the longer-term stock trend can be attributed to expectations for future earnings, the initial reaction to each report is usually caused by whether the company met, missed or beat analyst expectations for the last quarter’s actual performance.
Analysts change their estimates for actual performance over time, and we can track those changes for the market averages as well as individual stocks. It’s not surprising that third-quarter earnings estimates have dropped from a 3.1% decline in July to a 5.8% descent in September. This is nearly twice as bad as analysts had originally expected.
On the bright side, this means that the bar has been lowered, and actual earnings may have an easier time beating estimates on average, which may keep investor sentiment positive. That is usually what happens in this situation. However, if companies aren’t able to beat the already sandbagged earnings estimates, the shift in sentiment could be quite dramatic.
For example, despite the fact that expected earnings have been falling for FedEx over the last two months, the company still missed the average estimate when they reported on Sept. 16. This was a rare miss, and the stock dropped and broke support two days later.
Typically, estimates are kept low on purpose. However, that can also cause an outsized negative reaction when an unusually large number of companies miss their estimates during an earnings season. This almost always happens prior to a bear market. So a significant number of companies missing their estimates would be a critical red flag.
Setting positive future expectations and beating actual performance estimates are still possible. However, global economic fundamentals are weak enough that the opposite scenario is a real probability. Even though there have not been enough early reports to draw firm conclusions, performance has been weak so far.
We need to make sure we are watching the right factors to make sure our trades are aligned with the emerging bias as more reports start streaming in.
(You can learn more about identifying price patterns — like bearish engulfing patterns – and using them to project how far you think a stock is going to move in our Advanced Technical Analysis Program.)
InvestorPlace advisers John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next SlingShot Trader trade and get 1 free month today by clicking here.