Earnings Preview - Third Quarter 2014

Originally posted at Briefing.com

The third quarter had its share of intrigue for the capital markets. Thank you Russia. Thank you Scotland. Thank you oil. Thank you central bankers. Thank you Alibaba Group (BABA). And thank you (but not literally) ISIS.

When it was all said and done, index investors could give thanks that the S&P 500 climbed 0.6% in the quarter, setting a new record high along the way.

Things, however, didn't exactly end on an upbeat note. The S&P 500 declined 1.6% in September (or was it Sep-timber?) and kept on sliding at the start of the fourth quarter.

With the latter in mind, the third quarter earnings reporting period is shaping up to be a market-moving event, not just because earnings are supposed to drive stock prices, but because it can make or break the recent downtrend.

An Estimate Snapshot

Former Dow component Alcoa (AA) will report its results after the close on Wednesday, October 8, yet it won't be until the week of October 13 that the reporting for the September quarter picks up in earnest.

Per usual, the financial sector will be front and center in the first full week of reporting. Citigroup (C), JPMorgan Chase (JPM), Bank of America (BAC), Wells Fargo (WFC), Blackrock (BLK), American Express (AXP), Goldman Sachs (GS), and Morgan Stanley (MS) are among the luminaries from which investors will hear.

Unlike the second quarter, the financial sector is expected to report EPS growth. In fact, every sector is expected to report year-over-year growth, according to S&P Capital IQ.


Source: S&P Capital IQ

Note the downshift in earnings growth expectations for most sectors and the S&P 500 since July 1. That is a typical happening.

Earnings estimates almost always start out higher and then get revised lower as the quarter progresses when more information becomes available.

The downward revisions can create some hemming and hawing in the market as they occur, yet they also lay a path to "better than expected" results when the companies report as the estimate pendulum often swings too far in the other direction.

[See: Is the Stock Market Running on Borrowed Time?]

Hence, it is not unusual to see the final EPS growth rate end up being two to three percentage points higher than expected at the start of the reporting period. Second quarter earnings per share, for example, were expected to be up 6.5% on July 1 but ended up 10.8% when the reporting period was finished, according to S&P Capital IQ.

The positive surprise for the second quarter was helped in part by better than expected revenues, which increased 4.2% versus an expectation for 2.8% growth on July 1.

Third quarter revenues are projected to be up 3.9%, according to S&P Capital IQ. Not all sectors, though, are expected to report year-over-year revenue growth for the third quarter.


Source: S&P Capital IQ

Bad Dollar, Good Dollar

Earnings reporting periods are full of surprises — some good, some bad, and some ugly. Generally speaking, the real surprise would be if aggregate earnings growth did not surpass the reduced growth expectations.

A lot of attention has been paid to the strengthening dollar as being a negative for earnings prospects, but as we have stated in previous posts to this page, the dollar didn't shift into overdrive until the latter half of the quarter when the yen, the euro, and the pound got clobbered. Accordingly, we're unlikely to hear many disappointments for the third quarter pinned on currency translation issues.

What there will likely be more of are warnings that currency translation issues could act as a headwind in future quarters should the dollar's strength persist. That expectation is rooted in the understanding that the current value of the U.S. Dollar Index (86.69) is much higher than the average of 80.39 for the fourth quarter of 2013 and the average of 80.36 for the first quarter of 2014.

One shouldn't forget though that the dollar's strength has had the residual effect of driving down dollar-denominated oil prices.

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That's a positive factor for industries/sectors where oil is a major input in the cost of production. Accordingly, what the S&P 500 might lose in the way of growth from the energy sector, it could be made up with some positive surprises from the basic materials and industrials sectors.

To the latter point, note that the price of West Texas Intermediate Crude Oil averaged .31 in the third quarter of 2014 versus 5.76 in the same period a year ago. At its current price of .52, it is well below the averages of .66 for the fourth quarter of 2013, .52 for the first quarter of 2014, and 2.98 for the second quarter of 2014.

Lower oil prices have also translated into lower gasoline prices, which is a supportive factor for consumer spending. The dollar's strength will create some headwinds, but don't consider it a tornado that will wreck everything in its path.

What It All Means

Recent selling interest in the stock market, which has seen the S&P 500 drop as much as 4.6% from the record high it hit on September 19, has dampened expectations in front of the third quarter earnings reporting period.

What was once a full-steam ahead mentality has been supplanted with a wait-and-see mentality.

Will multinational companies stamp out concerns about the dollar's strength? Will companies suggest the U.S. economy is gathering strength, such that it will be able to offset any weakness abroad? Will companies be able to retain record-high profit margins?

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These are some of the pressing questions going into the reporting period and the answers will be provided soon enough.

With many stock prices having been pushed lower lately, the opportunity is there for outsized gains for those companies that can put investors' fears to rest. Those that don't will remain vulnerable to further downside.

Stay focused. It's show-and-tell time... and the tell for the market will be in the tenor of the fourth quarter guidance.

The latest report out of S&P Capital IQ shows fourth quarter expectations are high, too, with projected EPS growth of 12.1%. That's up from 11.5% on July 1 and is undoubtedly subject to revision.

About the Author

Chief Market Analyst