By Wallace Witkowski, MarketWatch
SAN FRANCISCO (MarketWatch) -- A lot of money is riding on this
earnings season...literally. As stock prices continue to rise into
uncharted territory, investors are going to be less forgiving this
earnings season after walking off the rough start to the year.
On Thursday, the Dow Jones Industrial Average (DJI) closed above
17,000 for the first time and the S&P 500 Index (SPX) set a new
closing high just north of 1,985 to end the Fourth of
July-foreshortened week following strong job numbers.
This week, investors will be girding for second-quarter earnings
season as Alcoa Inc.(AA) reports on Tuesday and Wells Fargo &
Co. (WFC) releases results on Friday. Earnings reports ramp up
considerably the following week with a slew of bank earnings from
such Dow components as J.P. Morgan Chase & Co. (JPM) and
Goldman Sachs Group Inc. (GS), along with other heavy-hitters like
Intel Corp. (INTC) and Google Inc. (GOOG)
"People are going to expect slightly better results this
quarter," said Randy Frederick, managing director of trading and
derivatives at Charles Schwab. "If there's solid data that earnings
are good, then the market can justify going higher."
Second-quarter earnings for the S&P 500 are currently
expected to grow by 4.9%, according to John Butters, senior
earnings analyst at FactSet. While that's down from the expected
growth of 6.8% when the second quarter began, Butters said in a
recent note that analysts have cut their earnings estimates by the
lowest amount since the second quarter of 2011, suggesting higher
expectations and a reluctance to lower the bar.
Earnings performance in the land of new record highs
Since the S&P 500 cleared its October 2007 record high back
in late March of 2013, expected earnings growth at the end of the
quarter has averaged 1.6%. Over the same period, actual growth has
averaged 3.8%, a difference of 2.2 percentage points, by the end of
the four peak weeks of earnings.
Coincidentally, the S&P 500 has gained an average of 2.2%
over the course of those four peak weeks of earnings. If we stick
to the averages, it possible anything less than 7.1% earnings
growth on the S&P 500 after most companies have reported will
be viewed as substandard, putting considerable pressure on the
market.
With heightened expectations relative to previous quarters, even
a better-than-average earnings season might not light a fire under
stocks. Stocks are anything but cheap and most people think they're
fairly valued, so it'll take something on top the usual two-thirds
of companies beating Wall Street expectations to drive stocks
higher.
Expectations are at the point where companies that issue
negative outlooks are getting beaten up more than usual and
companies offering positive outlooks aren't getting rewarded as
much as they have in the past. There's also the added pressure of
companies validating figures indicating economic growth is back on
track. On Friday, the unemployment rate fell to 6.1%, the lowest
since September 2008, as the economy posted its fifth straight
monthly gain of more than 200,000 jobs.
"We've got to have continued growth," Schwab's Frederick said.
"There's some room for valuation increases but not by a huge
amount."
But it's not just earnings that are under the microscope. As
with past quarters, earnings growth without appreciable revenue
growth is not going to cut it with investors, he said. That could
prove to be problematic as revenue isn't projected to improve all
that dramatically. Analysts are looking at 2.7% revenue growth in
the second quarter, Butters notes.
How overvalued are stocks really?
Whether stocks are overvalued relative to earnings really
depends on what you define an "average" valuation, FactSet's
Butters said.
The current forward price-to-earnings ratio is around 15.7, he
notes. If you look at the five-year average (13.3) and the 10-year
average (13.8), then stocks have been overvalued for about a
year.
But if you look at the 15-year average (15.8), which of course
takes into account the frothy days of the dot.com bubble, then
prices could have a little farther to go. Then again, that really
underscores the argument that lowered expectations may be a thing
of the past and that earnings are really going to have to step up
to the plate to keep pace with prices.
"It is interesting to note that the forward 12-month P/E ratio
would be even higher if analysts were not projecting record-level
EPS for the next four quarters," Butters said.
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