The Big Picture

Briefing.com Summary:

*Second-quarter earnings should be strong, but elevated valuations have raised the bar for what investors will consider a successful reporting season.

*Information technology and energy are expected to drive most earnings growth, making results from key semiconductor companies especially influential.

*Beating earnings estimates alone may not be enough; companies must validate lofty growth expectations to sustain the bull market.

In recent weeks we have focused on three metrics that ultimately reflect the same thing: expectations. Gross margins determine earnings power, forward P/E multiples reflect expectations for those earnings, and today's elevated price-to-sales ratio suggests investors remain willing to pay a premium for future growth.

In the coming weeks we are going to see changes across all three metrics. We just don't know how much change there will be and whether it will be positive or negative. That will depend in large part on what the second-quarter earnings reporting period tells us.

The second quarter should produce another excellent reporting season. The bigger question is whether "excellent" will be enough for a market priced for "exceptional."

Start Your Engines

The second-quarter blended earnings growth rate is 23.7%, according to FactSet. That is up from 18.3% at the end of March.

As a reminder, the blended growth rate accounts for the actual results of the companies that have already reported and the estimates for the companies that have yet to report, which is most S&P 500 companies. At this juncture, only 18 companies have released their results, so there is a long way to go to get to the finish line of this reporting period. 

Per usual, the banks will get things started. Collectively, their results should be quite good and led by the investment banks, which are in the catbird seat enjoying a robust IPO environment, an enduring bull market for stocks, and heightened volatility in the energy trade.

The financial sector has a lot going for it, although it isn't the main engine driving the expected second-quarter earnings growth. Its blended growth rate is 6.6%, which would be good for a 1.26 percentage point contribution to the overall growth rate, according to FactSet.

The main engines are going to be the information technology sector (no surprise there) and the energy sector (thanks to the surge in energy prices during the Middle East conflict). They are projected to report earnings growth of 62.9% and 126.4%, respectively, which would contribute 14.68 percentage points and 5.04 percentage points, respectively, or 83%, to the overall growth rate of 23.7%.

Every other sector is expected to make a nominal contribution (i.e., less than 0.9 percentage point), with the exception of health care (-1.10 percentage points), although that is due almost exclusively to special charges that were incurred by Gilead Sciences (GILD).

Earnings growth, then, should be positive across much of the index, but the aggregate growth rate remains heavily concentrated in two sectors.

The Crux of the Matter

What jumps out with respect to the information technology sector's earnings growth is how much of it is being driven by the semiconductor and semiconductor equipment industry. To be exact, that industry is 10.89 percentage points of the 14.68 percentage points the sector is expected to contribute to the overall growth rate.

Hence, what these companies report is not only important for the sector but also for the entire market, as the industry's earnings contribution would account for approximately 46% of the 23.7% blended growth rate.

Drilling down a bit further, two companies within the industry—Micron (MU) and NVIDIA (NVDA)—comprise 8.64 percentage points of the industry growth rate. We already heard from Micron. It had a blowout report (1,227% yr/yr earnings growth and 346% yr/yr revenue growth) that was accompanied by blowout guidance. Its 4.47 percentage point earnings growth contribution is "in the bag."

The stock, which had risen 267% for the year going into its June 24 report, gained as much as 19.7% on June 25, trading as high as 1,255.00. From there, it was nearly straight down. On July 7, MU hit a low of 891.66. That was a 29% drawdown from high to low in just seven trading sessions. Today it sits at 965.26, comfortably off its recent low but well below its post-earnings report high.

This price action is the crux of the earnings matter right now. Micron's earnings results and guidance were tremendous! The response by the stock was not, as investors questioned whether today's extraordinary growth and gross margins represent a sustainable earnings power that justifies the valuation already embedded in the stock.

Looked at another way, a lot of good future earnings news had been priced into the stock, so now it shifts from getting the benefit of every doubt to a prove-to-us-we're-not-wrong story. That transition can take time, so momentum investors move on, while long-term investors wait for the next leg of earnings growth to justify the valuation.

This is a crossroads the market cap-weighted S&P 500 could find itself at this reporting season since it is governed by the mega-cap stocks and momentum stocks.

Briefing.com Analyst Insight

After a blowout first-quarter reporting period in which the 28.9% earnings growth rate more than doubled the projected 13% growth rate seen on December 31, market participants have high expectations for a repeat performance.

That is evident in the upward revision for second-quarter earnings growth to 23.7% from 13.9% on December 31 and 18.0% on March 31. Estimates just keep going up and up and up, which is also evident in the forward 12-month EPS estimate. That sits at $368.17 today versus $303.38 on December 31 and $329.78 on March 31.

Meeting these high growth expectations would be impressive, but will it be enough? The S&P 500 sits on the doorstep of its all-time high as the reporting period is about to go into full swing. It is there because investors have been expecting not only to hear good earnings news but also unquestionably good guidance.

Will it be enough, though, for a company to provide a 5% upside EPS surprise (i.e., an "earnings beat") when it has typically been beating by 10% when it reports and/or guides?

Beating earnings expectations is now the expectation, but it is unclear what will be good enough to satisfy a bull market hungry for at least more of the same and, ideally, even better.

Thanks to the outsized results for the first quarter, the earnings bar for the second quarter is sky high, particularly for the tech stocks that command the most mind share and portfolio share. The reaction to their results will dictate the directional bias for the market cap-weighted S&P 500 in the near term.

The coming weeks will be a proving ground for the bull market, as we discussed last week. This reporting season isn't simply about beating estimates. It's about validating the elevated earnings expectations already reflected in stock prices.

--Patrick J. O'Hare, Briefing.com