Earnings Season: What to Watch

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

NEW YORK ( TheStreet) -- After a strong first quarter, the stock market, measured by the S&P 500 Index, got off to a weak start in the second quarter with a decline of -0.7% last week.

Investors focused on the Federal Reserve's lack of support for round three of quantitative easing in the minutes that were released from the March Fed meeting. As we noted a few weeks ago in our commentary, this is one of the 10 indicators we are watching that might foreshadow another spring slide in the stock market.

While macroeconomic data and events are likely to remain key drivers of the market this week, microeconomics will also garner investors' attention as companies begin to release their first-quarter earnings reports. While only a handful of S&P 500 companies report results this week, it is widely considered to be the start of earnings season with big, well-known companies like Alcoa ( AA) and JPMorgan Chase ( JPM) due to report first-quarter results.

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Four times a year, investors focus on the most fundamental driver of investment performance: earnings. The close connection between earnings and stock market performance can be seen in the fact that the S&P 500 Index and earnings per share have both risen about 80% over the past three years. A slowdown in earnings growth may indicate the same for the stock market.

Stock market momentum has stalled over the past few weeks during the period known as the pre-announcement, or confession, season -- so called because business leaders often use this period to offer investors guidance on how the quarter's results are shaping up relative to expectations.

This season, of the companies that pre-announced first-quarter earnings guidance in recent weeks, the ratio of negative-to-positive news was 3.0, worse than the average ratio of 2.3 since 1995.

The first quarter earnings season runs about four to six weeks, starting around two weeks after the close of the quarter. During this earnings season, we are paying special attention to the breadth of earnings growth, earnings guidance on upcoming quarters, and profit margins.

Breadth of Earnings Growth

We believe first-quarter earnings are likely to post a mid-single-digit percentage gain from a year ago as earnings growth continues to decelerate. The fourth quarter of 2011 marked the first time earnings growth fell into the single digits since the recovery began in 2009. The slowing growth rate for S&P 500 company earnings reflects not only slower growth among individual companies, but also reflects the shrinking number of companies expected to post growth in earnings for the quarter with about 20% of companies expected to reveal declines.

Just like the recent performance of the stock market, earnings growth is being driven by fewer companies. In fact, just one company, Apple ( AAPL), is expected to account for 1.4 percentage points, or about a third of the growth in earnings for the entire S&P 500. The same single company, Apple, accounted for 15% of the performance of the S&P 500 in the first quarter.

The fewer the number of companies that drive earnings growth (and stock market performance), the more vulnerable the overall market is to disappointments and declines.

Earnings Guidance and Revisions

The first couple of weeks of the first-quarter earnings seasons in April 2010 and April 2011 largely contained good news and drove earnings estimates higher. Earnings estimates for S&P 500 companies for the next year rose a greater-than-average 3% to 5% during the first couple of weeks of reports. But as the second half of the earnings season got under way in early May 2010 and May 2011, forward earnings guidance disappointed analysts and investors, and the pace of upward revisions declined sharply.

This year, we will be watching to see how much earnings expectations rise as the initial reports come in and if they begin to taper off sharply.

The consensus of analysts tracked by Thomson Financial expects earnings growth of 3% in the first quarter of 2012 (compared to the first quarter of 2011). While the bar of expectations may be low for the first quarter of 2012, looking further out on the calendar to the fourth quarter of 2012, year-over-year earnings growth estimates for S&P 500 companies remain high at 16.3%, according to data from Thomson Financial. Earnings guidance may result in substantial downward revisions to earnings growth for coming quarters, undermining support for the stock market.

Below we chart the change in earnings growth rate over the next 12 months for S&P 500 companies.

Chart 1: Spikes in Upward Revisions to Earnings Growth Preceded Stock Market Declines

Source: LPL Financial, FactSet Data Systems

Profit Margins

The analyst consensus forecast of 3% earnings growth in the first quarter is the slowest growth rate since the recovery in earnings began in 2009. The weakness stems from the end of profit margin expansion. Analysts expect earnings to track revenue growth of about 4%.

Over much of the past few years, companies were able to post earnings growth rates that were several times the pace of revenue growth as profit margins expanded, granting more profit per dollar of sales. However, the ability to post faster earnings growth than revenue growth has faded; rising costs have contributed to slower earnings gains relative to revenue.

In fact, nearly a quarter of S&P 500 companies are expected to report a year-over-year drop in earnings per share despite year-over-year revenue gains in the first quarter. Three sectors are expected to post earnings declines despite revenue growth. The most dramatic of these is the materials sector, where 5% revenue growth is expected to accompany a 15% decline in earnings.

Chart 2: Slowing Revenue and Earnings Growth

Source: LPL Financial, FactSet Data Systems, and Thomson Reuters

In this environment, those areas of the market able to sustain their profit margins are likely to be rewarded by investors. These sectors may include the information technology and industrials sectors. Companies in these sectors are those that appear likely to generate higher-than-average earnings growth rates in the first quarter.

Importantly, the companies that report early in the season are most often not the bellwethers they are commonly thought to be. We may not really know how overall corporate results for the first quarter are shaping up until early May, when about half of the S&P 500 companies will have reported.

In each of the past two years, as the last week of April unfolded, the stock market peaked and began to decline 16% to 19% as the back half of the earnings season got under way. We will be watching developments closely to determine if a repeat of that pattern will emerge again this year.
This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.

Jeffrey is Chief Market Strategist and Executive Vice President at LPL Financial.

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