Earnings season continues to move along with numbers that are fairly poor compared to last year, which shouldn’t be much of a surprise.
According to Yardeni Research, analysts expect average earnings per share to decline 44.3% on a year-over-year basis for the second quarter. However, expectations for earnings were so low, surprises to the upside are becoming the norm.
Extremely low expectations are an important reason why Coca-Cola (NYSE:KO) reporting a 32% drop in earnings this quarter in its Tuesday report was treated as good news. Investors pushed the stock up another 2.5% because the company beat expectations.
Overall, the S&P 500 has regained its losses since the first of the year. Investors are pricing in better-than-expected performance and a positive outlook.
But we feel the trend in margins is being under-reported. For example, average net profit margins for companies — net profit margin is the total profits divided by the total revenue — are hitting levels we haven’t seen since 2009.
According to data compiled by FactSet, the blended average net margin of the S&P 500 stocks that have reported already and those that haven’t yet is 7.1%. The average net profit margin in the fourth quarter of 2009 was 6.8%.
Focusing on margins helps us understand whether companies are beating earnings expectations by cutting prices and lowering investment in people, capital, innovation and development. At this point, the evidence suggests that is what is happening. Trends like that tend to be unsustainable without a fundamental shift in the economy.
As margins have declined, the earnings yield (earnings per share divided by the index price) of the S&P 500 has accelerated its fall. This is happening while the price of the stock index is rising.
Since 2011, this trend had been supported by easy monetary policy from the Federal Reserve, which is still true right now. However, with prices near their all-time highs and yields at a 10-year low, the probability of a break to new highs on the S&P 500 looks exceptionally low.
At this point, we need to include an important caveat: Stock prices are very high relative to valuations, and growth during a recovery later this year would have to be very large to justify these prices.
But that doesn’t automatically mean stocks will drop again. We think the data indicates there is a ceiling on the price — like a balloon bouncing against resistance — not a top.
We want to discuss valuations this week to help investors understand why we continue to urge a cautiously optimistic outlook.
And we aren’t the only investors thinking this way. During last week’s webinar, we discussed the CBOE SKEW Index (SKEW) and what it tells us about investor sentiment. In simple terms, the SKEW measures whether large investors are buying long puts as protection for their bullish portfolios. The higher it rises, the more demand there is for protection.
As you can see in the chart above, the SKEW (black line) is sitting just above the same level it reached the week the market started its collapse in late February.
We ran a study that compared the 20-day returns on the S&P 500 when the SKEW was above 140 and the market had been rising over the prior 10 trading days. We found that the short-term returns after that setup were negative 82% of the time.
The losses experienced in the 20-day period following the February setup were an outlier — we aren’t predicting a pullback that large — but it is still good to be careful.
The Bottom Line
The tone of this week’s update is a little negative because we feel that valuations have gotten ahead of even the most optimistic forecasts.
If there is an adjustment to the downside like we experienced in the second week of June, when the S&P 500 dropped 8%, we stand to gain from that by being able to roll out our short calls and sell puts on quality stocks that are near support.
Right now, there are fewer “pickings” because so many stocks are near their highs. This distorts the risk-reward profile too much.
At this point, we don’t expect many surprises from earnings season. And enough companies have reported earnings to feel confident that margins and profits are unlikely to be much worse than we have already seen.
John Jagerson & Wade Hansen are just two guys with a passion for helping investors gain confidence — and make bigger profits with options. In just 15 months, John & Wade achieved an amazing feat: 100 straight winners — making money on every single trade. If that sounds like a good strategy, go here to find out how they did it. John & Wade do not own the aforementioned securities.