What Investors Can Learn From the Recent Earnings Season
Say so long to one of the stock market’s last safety nets: the presumption that a flood of positive earnings reports can overcome the maniacal actions of high-frequency traders and other fast-on-the-trigger participants who care not one iota about company fundamentals or basic business or economic conditions. Stocks rally when companies issue strong results; isn’t that the way the system works? Maybe not anymore. Over the past month, we’ve seen a slew of upbeat earnings reports for the second quarter, yet the stock market took a licking anyway, with Standard & Poor’s 500-stock index sinking 5.3% in August, even after gaining 8.5% in the month’s final seven trading sessions.
If you exclude Bank of America (symbol BAC), which lost $8.8 billion because of a charge to earnings related to busted mortgage securities, average year-over-year earnings growth for companies in the S&P 500 clocked in at a cool 18% in the second quarter. That kind of performance normally wins plaudits from investors. This time, they sold and sold and sold, so much, in fact, that stocks came close to the 20% decline that qualifies as a bear market (at the market’s August 8 trough, the S&P 500 was down 17.5% from its April 29 high).
Much of the blame for the decline goes to a high-speed trading culture that treats “stocks” as a category on the order of gold or oil and glosses over the actual accomplishments of companies. Instead, these nearly mindless traders focus on such things as S&P’s downgrade of the U.S.’s debt rating or trouble in Greece, Italy and Spain. Let’s call these simple-minded sellers “stock vigilantes.”
Unexpectedly good earnings or an upbeat forecast from a leader like International Business Machines (IBM) or Amazon.com (AMZN) can still boost a stock’s prices and much of the market for a few hours. But no CEO, with the possible exception of Warren Buffett, is powerful enough to stop the undisciplined mass selling that erupts for the frailest of reasons.
As we work our way through September, historically a poor month for the market, stocks look inexpensive, especially in comparison with rock-bottom interest rates. At the September 1 close, the S&P 500 sold for 12 to 13 times estimated 2011 earnings, depending on whether you use strategists’ top-down forecasts or the bottom-up estimates of company analysts. (With half the year in the bag, 2011 forecasts look pretty solid and, indeed, some prognosticators are already judging the market’s price-earnings ratio on 2012 estimates.)
The economy’s slow, but business isn’t awful, at least not for big multinational companies. Among the companies whose results I consider earnings reports to watch, only Caterpillar issued dreadful second-quarter numbers.
But stock vigilantes have little use for what Wall Street calls the fundamentals, and they may continue to unload stocks this quarter. They have been bearish and will continue to express that sentiment by ditching index funds and index ETFs and piling into bonds. Before they return to stocks with conviction, these traders want concrete signs that housing has hit bottom. They want assurances that we’re not about to fall into a global recession. They could use a couple of months without any whispers of major bank failures. Bank-insolvency stories, even when denied or proved wrong, rip 200 points out of the Dow Jones industrial average even if the bank is European or Asian and only stock-market geeks can spell the institution’s name correctly.
The early line is for S&P 500 earnings to climb 12% in the third quarter compared with the same period in 2010. That means earnings gains for non-financial companies won’t be as vigorous as they were in the second quarter. That stands to be neutral to slightly negative for stocks through mid November. But if earnings aren’t the controlling factor for stock prices now, why would they matter much in three months? The answer: They might not. But how else are we supposed to follow the companies of which we’re supposedly part owners?
A few highlights from the recent quarter:
International Business Machines (IBM), the most-influential stock in the Dow Jones industrial average because it is the index’s highest-priced member, was one of the first blue chips to report, and Big Blue got earnings season off to a promising start. The reinvention of IBM -- it is now more a provider of computer services than a maker of big, mainframe computers -- has been a dazzling success, and I predict that the company will deliver solid third-quarter results.
Caterpillar (CAT). Before second-quarter reporting season got underway, I observed that investors would have a hissy fit if Cat sounded scared. That’s what happened. Cat’s earnings came in below expectations, and the CEO suggested that the immediate future was less rosy than many investors thought it would be. The comments fueled fears of a new recession, put a dagger into the hearts of all sorts of industrial stocks and lit the match that ignited the flash bear market.
Amazon.com (AMZN). The online retailer keeps prospering as consumers show they aren’t as broke or as terrified as “consumer confidence” indexes suggest they are. People just want value and convenience, and Amazon offers both. The company’s earnings and revenues ought to exert more influence over stocks for the next quarter or two because results that are tied directly to the holiday shopping season can quickly turn bears into bulls and vice versa.
Disney (DIS) is performing much better than the tale of the busted consumer suggests and beat its earnings target handily. Yet the stock sank on earnings day because Disney put a few cautious notes in the release and, perhaps more important, because the entertainment giant had the misfortune of reporting its earnings right as the market first had to deal with S&P’s Treasury-rating downgrade. At $33.38, the stock sells for 13 times estimated earnings for the fiscal year that ends this month. With Disney’s (unusual) annual dividend due in December, the stock seems like a reasonable buy. The risk is that the vigilantes will mercilessly pound Disney, a member of the Dow industrials, when they return in force.