We are on the cusp of another earnings season and it looks like a record breaker. The expectations are pretty rosy to say the least. Financials are expected to have a 115% increase year over year. Industrials, a whopping 330%. Consumer Discretionary companies are looking at a 152% increase as well. Whew!
Well, let’s not get too far ahead of ourselves. Sure, the numbers will be great but remember what year, the year over year is. So, while the numbers may look great, they are compared to a disastrous period for the US economy. Any increase in economic activity over last year will be substantial. That is not to say that companies aren’t doing very well at this juncture, I just like to caution people about earnings growth comparisons.
Knowing we are in for a tremendous earnings season, you ask, what should we be looking at instead?
Since I like to keep things simple, here are a couple of things to watch for:
One, The most obvious thing is what companies say about their prospects for the future. Typically, it’s bright and filled with flowers and confetti but how can any company paint a rosier picture than what they already have? One quarter out, comparisons will be similar year over year. The third quarter of last year was not a gangbuster quarter by any means but it was better than the second quarter so companies can see that they will also have very good growth year over year for the third quarter. It will be interesting however, to see what they say about the fourth quarter of this year and the first quarter of next year. I can guarantee there will be no 115% earnings gains. Companies will need to strategically emphasize that this earnings growth is an anomaly and they will eventually return to a more consistent pattern of earnings and revenue gains.
Two. I think a lot of this robust earnings momentum has been priced into stocks and while that momentum may remain for a bit more, there will be a point where investors, who have ridden the growth train since May of last year, will finally get off. All good things come to an end eventually and we are nearing that end. The bulls of this World can make a very strong case for this rally to continue and I understand their views but capital has been flowing into equities for so long that what we are now seeing is a stretching of justifications. You can only justify an action for so long and then you need to get out before the damage starts.
Ah, you say. You have been pushing the inflation story for months and inflation net net, is good for stocks. More money in circulation means more spending, more earnings as companies take advantage of price increases. All true, but with inflation, interest rates should increase and the cost of borrowing will increase. Short term, thats not a problem for most companies since cash flow is good, no need to borrow, but as inflation becomes extended, things will get a little more expensive. In addition, wages will rise accordingly and a cycle is in place. That will impact earnings no doubt. This is not happening tomorrow, nor is it happening this summer, but I would expect to see some negative impacts of inflation to start hitting home by mid to late fall and thats where you will send the slowing momentum of earnings take hold.
With the theory that stocks usually price companies six to nine months out, expect to see some sort of sustained sell off in the fall. A debacle? No. A panic? Probably not. A sustained correction? I think so. As I have repeatedly said, a correction can be a very healthy thing. Realign stocks and the economy. Recalibrate portfolios and prepare them for the next phase whatever that might be. All things a healthy market needs to continue to grow.
Granted, my viewpoints are simplistic and that is with good reason. The more complex you make things, the less you understand. Keeping things simple puts the onus on oneself. If you invest in some complex strategy and it fails, you are more apt to blame the strategy but the reality is, its your own fault. You put money into something you did not understand and you suffered. I look at everything in the simplest terms and have a pretty good understanding of why something worked or it didn’t. Helps me sleep better at night.
Great advice as always!!