Wednesday, July 10, 2013

The Big Surprise We’ll Get from Public Company Earnings This Quarter

By Sasha Cekerevac

With corporate earnings season about to begin, many investors are anxiously awaiting the results to see if the S&P 500 can continue its strong showing.

Naturally, with the index showing such outsized returns over the past six months, many investors are getting nervous. And the investors who have been left on the sidelines are waiting for some signal indicating whether to get into the market at the current level or wait for a larger pullback.

One worrisome sign for the S&P 500 is that the forecast for the corporate earnings growth rate has continued to come down. According to FactSet, a global leader in financial information research, the current estimate for the corporate earnings growth rate during the second quarter of 2013 is just 0.7%. This is a significant drop since March 31, 2013, when the estimate for the corporate earnings growth rate during the second quarter was 4.2%. (Source: “Earnings Insight,” FactSet Research Systems Inc. web site, July 5, 2013.)

That news might confuse some investors, because the S&P 500 is still near its all-time highs.

I believe that a dichotomy has been generated by the investors’ reactions to the easy monetary policy stance by the Federal Reserve. When the Federal Reserve began discussing the possibility of reducing its asset-purchase program last month, sellers then emerged and impacted the S&P 500.

While the index has since rebounded, I believe investors now need to focus on the underlying fundamentals, including the potential for growing corporate earnings into the future. As the sentiment begins to shift away from Federal Reserve policy and to actual drivers of business growth, like corporate earnings strength, the S&P 500 will be affected.

But, and I have stated this before, I believe interest rates are set to continue increasing. This will begin to hurt corporate earnings and impact valuation levels for the S&P 500.

The chart for the S&P 500 is featured below:

S&P 500 Large Cap Index Chart

Chart courtesy of

While corporate earnings have increased substantially over the past few years, it appears we are at an inflection point where investors in the S&P 500 are pricing in a far too optimistic picture of the future.

Current investors are essentially predicting that the transition by the Federal Reserve to reduce its asset-purchase program will run perfectly, and the S&P 500—as well as the American economy—can handle higher levels of interest rates.

The current level of the S&P 500 has, in my opinion, priced in most of the good news forecasted over the next year. This leaves the market vulnerable to external shocks.

As I have mentioned, I believe that the S&P 500 will trade in the range, culminating with a significant sell-off this fall. As we move into September and October, when the Federal Reserve will likely begin reducing its asset-purchase program, I believe most investors will not be prepared, and the S&P 500 will suffer a significant pullback.

With corporate earnings growth slowing down, investors can’t expect the S&P 500 to achieve higher levels. If the index were to pull back significantly, at some point the low valuation will make stocks attractive, given the level of corporate earnings.

But until that point, it appears that the risks continue to increase as corporate earnings slow down, and we are about to enter a significant transition period regarding monetary policy.

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