I/B/E/S Strategist: Second-Quarter Earnings Look to Be Robust

Corporate earnings in the first quarter of 2000 can be described as nothing less than stellar. Even though the second-quarter season, which gets under way in earnest in a couple of weeks, isn't shaping up to be quite the same kind of rocket ride, the picture looks pretty promising.

I/B/E/S found that 69.9% of the companies in the S&P 500 index beat the I/B/E/S consensus in the first quarter. That was one of the largest percentages of positive surprises since the first quarter of 1999, when 66.1% beat consensus. The S&P 500 had a significant positive surprise, with its constituents beating expectations by an average 6.2%. The close of the first quarter had taken even the most optimistic of analysts by surprise.

Heading into the second quarter the earnings momentum continued, with the S&P aggregate quarterly estimate increasing every week since May 29. However, as we wind up the second quarter, this momentum appears to be slowing.

For the week ended June 23, second-quarter consensus earnings estimates for the S&P 500 declined vs. the previous week as analysts formed a better picture of the quarter and began to trim their earnings estimates. The I/B/E/S revision ratio (the number of estimates raised vs. the number of estimates lowered) confirms this. Last week was the second straight in which the ratio fell below 1.00; before that, it had been above 1.00 all year.

With lower earnings projections week over week, it would be easy to assume the worst, but this is clearly not the case. For the most part, it's normal to see estimates come down as the year progresses, as analysts are usually overly optimistic in the beginning of the year.

This is especially true at the close of a quarter. We have entered the "confession season," when companies begin to send preannouncements to Wall Street regarding quarterly results. Considering that most of these announcements are warnings of estimate shortfalls, the I/B/E/S revisions ratios historically tend to be below 1.00 as analysts fine-tune downward. In fact, the first quarter marked the first time I/B/E/S has ever seen the ratio above 1.00 all throughout confession and earnings season. That alone should bring to the surface the magnitude of first-quarter corporate earnings strength and the realization that the second quarter is not witnessing a weakening in corporate earnings expectations, only a reversion back to normal trends.

In fact, judging from preliminary data, the second quarter may turn out to be quite robust. During the confession season, companies with the motivation not to surprise Wall Street with earnings that are unusually different than consensus will preannounce quarterly earnings results. Historically, most preannouncements are negative (about 80%). Heading into the second-quarter reporting period, confession season has been quiet with only 66% negative, indicating a healthy second quarter. Also, given the history of positive surprises, quarterly earnings growth figures (currently 17% for the S&P 500 on a pro forma basis) may have upside potential.

Potential Second-Quarter Pitfalls

The overall earnings front remains healthy in corporate America, but there are, of course, a few "snags" that must be monitored closely. First and foremost, of course, are interest rates, and the obvious effects they have on a corporation's bottom line. The Federal Reserve started raising rates about a year ago, first to reverse earlier easing resulting from the Asian crisis and Russian bond default and then as a measure to cool a torrid economy. It takes time for the rate increases to filter through the economy, and corporate earnings may feel the pinch from these initial rates hikes beginning in the second quarter.

Another potential scenario eating into corporate profits is unfavorable currency translations. This affects multinational companies that lose money in the conversion process. Companies hard-hit in the second quarter include those with European exposure, openly acknowledging the weak euro/strong dollar has taken away from their bottom line.

Finally, the rebound in oil prices will affect those industries sensitive to fuel costs, and while there appeared to be some temporary relief earlier on, this issue has once again resurfaced.