Typical bearishness as we enter Q3 earnings … what you should actually expect … despite overall bullishness, we’re keeping our eye on three headwinds

 

Here we are again on the cusp of another earnings season.

Per tradition, cue the doom-and-gloom headlines…

Perfect, thank you.

There’s a concern that Q3 earnings will bring disappointments, certainly more so than we saw in Q2.

That’s fair. There are several headwinds impacting earnings that we’ll discuss today.

However, we still believe we’re in store for a net-positive earnings season that helps shake the market out of its current malaise – despite the negative headlines.

To understand why, let’s pull back the curtain on the little game that Wall Street likes to play.

***It seems like every earnings season, investors are subjected to warnings of earnings disappointments

Yet just about every time, the numbers come in better than expected.

How? And why?

Because Wall Street is incentivized to sandbag earnings.

Especially in an uncertain economic environment like we have right now.

Our technical analysts and the team behind Strategic Trader, John Jagerson and Wade Hansen, explained this phenomenon last year, and it’s no less applicable today.

Here they are, revealing how this song-and-dance works:

It’s simple. You lower earnings expectations and then watch corporate America beat those lowered expectations.

You see, Wall Street analysts are professional sandbaggers.

Buy-side analysts — those that work for firms that buy stocks or recommend buying stocks — are amazing at underestimating the true strength of a company’s revenue and earnings potential.

Sell-side analysts — those that work for firms that issue, or sell, stocks — are amazing at finding and emphasizing any little good piece of news about a company and its revenue and earnings potential.

***Why would analysts intentionally sandbag the numbers?

John and Wade tell us the answer boils down to incentives.

Analysts get paid to provide information. If the information they provide makes their clients happy, they continue to get paid. If that information makes their clients unhappy, watch out.

Buy-side analysts know that clients who pay for their insights are going to be much more forgiving of a recommendation that overperforms, rather than underperforms, an earnings-estimate.

Back to John and Wade:

Quarter after quarter, analysts lower expectations on Wall Street by cutting their estimates in the run-up to earnings season, setting everyone up to be pleasantly surprised when the numbers come in “better than expected.” After all, it’s much easier to clear a lowered hurdle.

The amazing thing is that everybody knows this is happening, yet it continues to work a surprising amount of the time.

FactSet – the go-to earnings analytics company used by the pros – acknowledged this last Friday, when it reported on earnings growth expectations for Q3 results (emphasis added):

The S&P 500 is expected to report (year over-year) earnings growth of 27.6% for the third quarter.

Given that most S&P 500 companies report actual earnings above estimates, what is the likelihood the index will report actual growth in earnings of 27.6% for the quarter?

Based on the 5-year average improvement in earnings growth during each earnings season due to companies reporting positive earnings surprises, it is likely the index will report earnings growth of nearly 35% for the third quarter, which would be the third consecutive quarter of (year-over-year) earnings growth above 30%.

***Even though we anticipate overall positive earnings, there are still headwinds that will separate the great companies from the struggling companies

Sandbagging aside, three dynamics will leave their mark on troubled companies this quarter…

Supply chain problems, labor shortages, and inflation.

Here’s Reuters highlighting the first two:

In the run-up to earnings season, a number of companies have issued downbeat outlooks.

FedEx Corp said labor shortages drove up wage rates and overtime spending, while Nike Inc blamed a supply-chain crunch and soaring freight costs as it lowered its fiscal 2022 sales estimate and warned of holiday-season delays…

U.S. companies have so far this year kept profit margins at record levels because they have cut costs and passed along high prices to customers. Some investors are anxious to see how long that can go on.

Even though Q3 earnings “starts” this week, as of last Friday, about 4% (21) of S&P 500 companies had already reported.

Scanning the conference call transcripts of those 21 companies, FactSet searched for specific terms related to several problem factors (e.g., “labor,” “supply chain,” etc.).

Here’s what they found:

Supply chain disruptions and costs have been cited by the highest number companies in the index to date as a factor that either had a negative impact on earnings or revenues in Q3, or is expected to have a negative impact on earnings or revenues in future quarters.

Of these 21 companies, 15 (or 71%) have discussed a negative impact from this factor.

After supply chain disruptions, labor shortages and costs (14), COVID costs and impacts (11), and transportation and freight costs (11) have been discussed by the highest number of S&P 500 companies.

By the way, those transportation and freight costs will be interesting to watch given soaring oil prices.

Yesterday, U.S. crude popped more than 2% to a seven-year high of $81.50 a barrel. Since the end of last October, crude is up more than 120%.

This dovetails us into inflationary pressures.

***Yesterday, legendary investor, Louis Navellier, commented on inflation risk in his Accelerated Profits update

For newer Digest readers, Louis is a market legend. Over the decades, he has developed a high-tech trading system guided by preset algorithms – basically, step-by-step computer instructions. It’s this use of predictive algorithms that led Forbes to name him the “King of Quants.”

Given the emphasis on numbers and quantifiable data, it’s no wonder that Louis is closely watching what’s happening with inflation and its impact on earnings.

From Louis’ Accelerated Profits update:

Inflation still remains a bit of a wild card, as the latest Personal Consumption Expenditures (PCE) reading showed inflation climbed 0.3% in August. It is now running at a 4.3% annual pace, or the highest level in 31 years.

Core PCE, which excludes food and energy, also rose 0.3% in August and is now running at a 3.6% pace in the past 12 months…

The third-quarter earnings announcement season will reveal which companies can still maintain strong earnings and sales growth in the current environment.

What this means is that the market will grow more narrow and more fundamentally focused, as individual and institutional investors grow more selective in their stock picks.

If you’re wondering whether your stocks are strong enough to hold up in this “narrow” market, Louis offers a free tool that’s rooted in the same quantitative computer algorithms he uses to find his winners.

The Portfolio Grader gives a stock an instant grade, like a report card, based on eight fundamental factors. I encourage you to see how your stocks measure up.

***A quick note before we sign off

Last week, Louis Navellier and Eric Fry’s Escape Velocity event highlighted the huge profit potential these two legendary stock investors have found in an often-overlooked corner of the options market.

Basically, the event pulled back the curtain on how professionals use options. It’s a strategy that often transforms small stock increases into truly outstanding gains.

If you missed the evening, click here to watch the free replay.

Just a heads-up that the price of Louis and Eric’s research on this strategy will be going up tonight at midnight. If you join them today, you’ll be locking in the lowest price we’ll ever offer on this service.

To illustrate what it can do, Louis’ back testing showed that instead of stock gains of 55%, 79%, and 159%, this strategy could have racked up options wins of 2,586%, 3,033%, and 4,157%.

Here’s that link again to watch the replay of the event.

Wrapping up, it’s unlikely that earnings season will be a bullish blowout, but we still expect good things. We’ll keep you updated.

Have a good evening,

Jeff Remsburg