EmailThe S&P 500 surged 10.0% in the first quarter and every sector went along for the ride. The Health Care sector led the pack with a 15.2% gain while the Basic Materials and Information Technology sectors brought up the rear, each gaining 4.2%.
One of the least talked about features of the equity market rally in the first quarter is that it occurred at the same time earnings growth estimates for the first quarter were being reduced. In fact, while every sector was going up in price, earnings growth estimates for all but the financial sector were being cut.
According to FactSet, first quarter S&P 500 earnings are now expected to decline 0.8% on a blended basis versus the 2.2% growth rate projected on December 31. First quarter revenue, meanwhile, is expected to be up just 0.3%.
It is clear that the bar for the earnings reporting period has been set low once again. That is sure to produce a fair number of positive surprises. With the outsized move in the first quarter, however, and the understanding that 88% of S&P 500 companies are trading above their 200-day moving average, the response in many instances may not be as big as the earnings surprise -- unless it is a negative surprise.
Down, but Not Out
While it is notable that first quarter earnings estimates have been revised lower, it is also notable that the scope of the revision is not excessive.
The three percentage-point decline in the bottom-up EPS estimate for the first quarter (to $25.55 from $26.34) over the first two-and-a-half months of the quarter is less than the average three and a half percentage-point reduction seen over the past ten years, according to FactSet.
That encouraging revelation loses some luster with the realization that first quarter earnings for 2013 are still projected to decline, which is something entirely different than saying they are expected to increase 7% now versus 10% two-and-a-half months ago.
The major drags this quarter are expected to be the energy, information technology, health care, and industrials sectors, all of which are projected to register year-over-year declines in earnings growth.
| Sector |
December 31 |
Today |
|---|---|---|
| Utilities | 10.6% | 7.9% |
| Financials | 3.4% | 3.5%(a) |
| Consumer Discretionary | 7.2% | 1.4% |
| Consumer Staples | 2.8% | 1.0% |
| Telecom Services | 3.9% | 0.3% |
| Materials | 7.3% | -0.2% |
| S&P 500 | 2.2% | -0.8% |
| Industrials | 2.0% | -2.1% |
| Health Care | 0.3% | -2.2% |
| Info. Technology | 0.9% | -3.9%(b) |
| Energy | -2.7% | -4.9% |
(a) If AIG is excluded, the growth rate increases to 7.9%
(b) If Apple is excluded, the growth rate improves to 0.5%
Revision Writing on the Wall
Coming out of the fourth quarter reporting period, the writing was pretty much on the wall for analysts that earnings estimates were too high.
According to Thomson Reuters, 94 S&P 500 companies issued negative guidance for the first quarter versus just 23 companies that issued positive guidance. The negative-to-positive ratio of 4.1 is the highest since the third quarter of 2001 and well above the long-term aggregate of 2.4.
Guidance is always important, but this period should prove particularly instructive as it will help shed light on whether the market has gotten too far ahead of itself with its economic recovery expectations.
It is a popularly-held belief that economic growth will accelerate as the year progresses. That view is embedded in current earnings growth forecasts, which call for 4.7% growth in the second quarter, 10.1% growth in the third quarter, and 15.6% growth in the fourth quarter.
FactSet points out that, despite the lofty earnings growth estimates for the back half of the year, analysts are projecting revenue growth of only 4.5% and 2.3% for the third and fourth quarters.
Something is going to have to give there. It is much more likely in our estimation that earnings growth forecasts will come down to meet the lower revenue projections than revenue forecasts will go up to meet the lofty earnings growth estimates.
Keeping the Faith
Clearly, the stock market held up just fine in the first quarter as earnings estimates came down. Its resilience can be attributed in part to incoming data on home sales, business investment, consumer spending, and employment that supported the second-half recovery thesis.
It is premature, though, to jump to foregone conclusions knowing that: (a) many reports only covered the months of January and February (b) the March reports on consumer confidence showed sharp drops versus February (c) eurozone uncertainty has increased from the start of the year with the inconclusive Italian election and the Cyprus bail-in and (d) China is working to curb rising inflation and property speculation.
No matter the news, the stock market held true in the first quarter to its faith in the policy support provided by the Federal Reserve. That trumped all else, including the negative earnings revisions.
While there has been some discussion within the FOMC about tapering the Fed's purchases of government securities sooner rather than later, the Three Monetary Musketeers -- Ben Bernanke, William Dudley, and Janet Yellen -- continue to make a case for shooting down such assertions.
Their staunch defense of current policy helped the market advance to a new, all-time closing high on the last trading day of the first quarter.
In keeping with the spirit of a bull market supported by ultra-easy monetary policy that encourages speculation, many stocks have gotten overbought on performance chasing. Within the S&P 500, Netflix (NFLX) could be held out as such an example. Shares of NFLX are up 104% year-to-date, trade at 138x (there is no decimal there) estimated 2013 earnings, and are currently 94% above their 200-day moving average.
Those gaudy statistics imply there isn't room for error when the company reports earnings. What they also suggest is that downside risk outweighs upside potential in the near term since a lot of good news has already been priced into the stock. Netflix could deliver on earnings and guidance, but such good news isn't likely to elicit as strong a reaction at this juncture as disappointing earnings and/or guidance will.
Investors should take such considerations into account this reporting period, particularly if they own a highflying stock like Netflix.
Exploring One's Options
In the Market View we published on March 18, we highlighted some approaches for investors aiming specifically to guard against downside risk. Hedging through the use of options and reducing exposure to stocks trading well above long-term moving averages were included in that mix.
A prudent hedging strategy we saw discussed by Steven M. Sears in his "Striking Price" column in Barron's is a stock replacement strategy. With this approach, he writes one could use some of the profits from selling a stock to buy a call option on the stock. This leaves you with some skin in the game so to speak, because the call value will increase if the stock goes up in price. However, if the stock goes down in price, you will have the residual mental satisfaction of knowing you booked some profits ahead of time.
Alternatively, volatility is inexpensive right now, so buying a put option on the broader market could be used as a hedging strategy in the event one wanted to hold onto their stock.
Options carry their own risk, so be sure to check with your financial adviser before using them, yet they could prove useful this reporting period given the strong moves that many stocks have already made.
What It All Means
The first quarter reporting period begins on April 8 with Alcoa's report after the close of trading. If history is any indication, first quarter earnings growth will end up better than the 0.8% decline that is currently expected.
Keep in mind that earnings season is euphemistically referred to as "silly season" and for good reason. Counterintuitive trading responses are often seen.
How a stock traded leading up to the company's report often plays a role in such responses. Other factors like short covering or news of a management change can drive some unexpected trading responses as well.
Market participants have been conditioned to hear better-than-expected earnings news, but when stocks get ahead of themselves, as many have, it gets increasingly challenging for companies to live up to the high expectations embedded in the stock price. Accordingly, one shouldn't be surprised this reporting period if stocks don't make a big move on good earnings news. What needs to be taken into account more fully is the risk of a big, downside move in the event of a disappointment.
Consistent with the theme of risk control we have been highlighting for some time, we have assembled a list of 106 S&P 500 stocks that are trading 20% or more above their 200-day moving average. If you'd like a copy of the list, please email me at pohare@briefing.com.
Regular readers of The Big Picture know that we focus on fundamentals. That fact notwithstanding, we appreciate that technicals play a big part in trading decisions and that those technical factors could be instrumental in helping to explain why some stocks fail to take off on good news, while other stocks get hammered on bad news, during the upcoming silly season.
