Sluggish Earnings Will Have Limited Impact on Stocks

NEW YORK (TheStreet) -- Investors are currently dealing with a "tug of war" type battle in stock markets, balancing steady improvements in macro data with the possibility that the Federal Reserve will start removing stimulus.

Employment numbers for June were very strong, and data from April and May were revised higher, bringing the 12-month average in the non-farm payrolls to 182,000. The general consistency of these numbers has led to a more confident belief that the economy is ready to stand on its own two feet, and the S&P 500 is holding within striking distance of its all-time highs. But without added support from the Fed, the attention will have to turn back to fundamentals, and there is little on the horizon that looks capable of fueling another run higher in global stock markets.

As earnings season gets underway, it is clear that expectations are weak. Markets are looking for earnings growth in S&P 500 companies to come in under 1% for the second quarter.

On the revenue side, things aren't much better. Four years into the economic recovery, there is progress that has been made in earnings growth. But most of that progress was driven by cost cutting rather than elements such as increased sales and broader revenue growth.

At this stage, there is not much companies can do to remove costs from businesses, and the economy itself has not picked up enough to support strong improvements in the key areas of weakness. The result is we are caught in a low-earnings-growth environment, and the market's tepid expectations for second-quarter earnings are a reflection of this.

This is also an environment where operating margins have been a point of strength and a major source of support for corporate performances. This should continue during the second quarter, but don't expect this strength to be matched on the revenue side.

Most of the growth seen post-2009 came from the fact that companies were building off of a weakened base (created by the credit crisis a year earlier), and the outlook has since changed. The main question now is whether or not this scenario will be enough to propel investor optimism and generate another run higher in the benchmark indices.

Ideally, when we invest in a company, we want to see profit growth. Without improvements on the revenue side, it will be very difficult for companies to see growth in the bottom line. But at the same time, the S&P 500 is still trading within reach of its all-time highs. This is largely because (from a comparative standpoint) there is not much to be excited about in other asset classes or in stocks from other countries.

In fixed-income, for example, a rising interest rate environment would reduce returns as bond prices fall. Weak manufacturing data in China, recessionary conditions in Europe and collapsing stock markets in Japan and emerging markets remove these areas as viable alternatives for near-term investment. So, while growth projections in the U.S. remain sluggish, this does not necessarily mean that a poor earnings season will lead to major bear declines.

But which areas should we be watching? There are only a handful of sectors that are likely to post actual earnings growth in the coming weeks. Potential strength could be seen in financials. Early earnings releases will be seen from JPMorgan Chase ( JPM) and Wells Fargo ( WFC), and the outcome from these reports will be used as an indication of what to expect through to the later parts of the season.

As a whole, financials are projected to see earnings growth just under 20%, which is much better than what is expected for the broader market. The financial sector is an area that will benefit from increases in interest rates, as this type of environment supports its traditional business models.

Overall, however, there are reasons to believe that a mediocre earnings seasons will not create large bouts of profit taking and send the benchmarks back toward new lows. Given the lack of investment alternatives, the bearish impact of slow growth should be limited.

At the time of publication the author had no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

Richard Cox is a university teacher in international trade and finance, focusing primarily on macroeconomics and price behavior in equity markets. His articles appear on a variety of websites, including MarketBulls.net, Seeking Alpha, FX Street, and others. Investing strategies are based on technical and fundamental analysis of all the major asset classes (stock indices, currencies, and commodities). Trade ideas are generally based on time horizons of one to six months.

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