The stock market has again this year followed the pattern of the past two years with a solid gain of roughly 10% during the first quarter, followed by a spring slide beginning in April of at least 10%, stemming from a combination of weaker economic growth and concerns over European debt problems. This year may also continue to follow the pattern of performance around earnings season. In the past nine quarters encompassing all of 2010 through the first quarter of this year, the S&P 500 posted an average gain of 3.14% during the six-week period beginning in the last week of the quarter (the end of the pre-announcement period) when the results of a little more than half of the S&P 500 companies are reported. During the other weeks of each quarter, the stock market has posted a loss, on average, of -1.46%.
The next six weeks may again follow the pattern and offer investors better relative performance for several reasons: 1. Investors are braced for disappointment. Companies that have "pre-announced" their second-quarter results to offer investors guidance have had mostly bad news. Of the 129 companies that pre-announced second-quarter earnings guidance in recent weeks, the ratio of negative-to-positive news was 3.5, worse than the average ratio of 2.3 since 1995. This is even worse than the 3.4 in the fourth quarter of 2008, during the peak of the financial crisis. This has left investors expecting more bad news, leaving the potential for stocks to perform better if the news is not as bad as feared. 2. Expectations are low for earnings growth. Profits for S&P 500 companies are expected to be up about 6% to 8% from a year ago, but flat compared with a year ago when excluding the financials sector -- benefiting from a one-time boost due to a record-breaking loss recognition by Bank of America ( BAC) taken a year ago. 3. Companies are already beating expectations. Of the 14 companies that have reported actual results for the second quarter, 78% have exceeded analyst estimates. This suggests earnings may come in better than analysts and investors expect. It may seem like companies are likely to post poor results given the sluggish U.S. economy and recession in Europe. But corporate profits are driven more by the solid growth in business spending and manufacturing than the more consumer spending-driven gross domestic product, which has slowed. While Europe is experiencing a recession, solid growth is expected in emerging economies. U.S. companies sell three times as much to the emerging markets than to Europe, supporting revenue growth. While profit growth has slowed, it is unlikely company profits will post results that are unchanged from a year ago (excluding the one-time gains in the financials sector).
Three key items we will be watching for this earnings season are the impact of Europe, rising pension expenses and falling commodity prices. 1. We will be gauging the impact of the European recession on profits and guidance for future quarters. Some companies are more exposed to Europe than others. It could be more fear of the unknown than the current impact on profits that causes some corporate leaders to lower their outlooks. While Europe is a convenient "excuse" some companies may use to justify weak results, overall we expect relatively few Europe-driven earnings disappointments. 2. We will be measuring how much higher pension expense weighs on profits due to the decline in interest rates hurting returns and increasing the amount companies must contribute to fund pension plans. Many companies have addressed this in recent years, but the total billions of dollars to maintain adequate funding remains a challenge for a number of companies. The highway bill in Congress includes an adjustment to how pension contributions are calculated that, if passed, should provide some relief to companies. 3. Commodity prices are major drivers of S&P 500 profit growth. Counterintuitively, falling commodity prices weigh on corporate profits due to the weaker contributions from sectors such as energy and materials not fully offset by the benefit of lower fuel costs and improved disposable income from consumers. During the second quarter, commodity prices fell sharply. The moves in prices tend to affect profits with a bit of a lag. We will be watching to see how this translated into profits for energy and materials companies during the quarter and for clues as to how their profit growth may slow later in 2012. 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 quarter are shaping up until early August as the six-week period of performance draws to a close and about half of the S&P 500 companies will have reported.