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A Preview of Q2 Earnings

Is Q2 the quarter where earnings disappointments impact the markets? After 14 quarters of double digit year-over-year earnings growth, is this the Q that blindsides investors? Its too early to tell, but there are quite a few warning signs to consider.

In particular, I am watching these 5 elements this earning season:

• Bellwether Misses: 3M, EMC, Alcoa, Lucent -- each of these firms Q issues has been spun as "specific to the company" and not a sector-wide or market issue. If these numbers rise, it becomes harder to believe the company specific mantra;

• Compare the Numbers:  Corporate management is keenly aware of the big 3 issues investors watch: Revenue shortfalls, profit disappointments, weak guidance. Keep on eye on how this Q compares to prior Qs in terms of these 3 data points -- especially how they compare with the past few recent Qs.

• Options Options Options:  Between the option backdating scandals, and more recently, "spring-loaded options," we haven't even discussed the expensing of options. (Options expensing are a large part of the reason tech stocks have gone nowhere). Options, in all their myriad forms, are weighing on equity prices.

• Earnings Management: Between Sarbanes Oxeley and execs going to jail, there's no doubt the quality of accounting is significantly higher than it was. But what of the overall SPX earnings management?  There has been a disproportionate impact of share buybacks as a form of earnings management; Trimtabs notes nearly half a trillion dollars worth of stock repurchases were made in 2005. Measuring operating earnings in dollar terms (not per-share net basis) shows year over year gains of less than 8% -- not the 12-15% widely reported.

Today's WSJ has an article detailing how companies are increasingly issuing debt to pay for share buybacks. As Merrill Lynch's David Rosenberg describes it, there's a good deal less to the corporate bottom line than meets eye.

• Leadership:  What sectors are putting up the strongest overall numbers? Is it finance technology and consumer discretionary? Or, are materials, energy and utilities leading? The sectors providing the most disproportionate bang for the earnings buck are quite revealing as to what is going on in the economy.

These five elements will determine whether this earnings season is a pleasant surprise or a  disappointment.

Note that Wall Street tends to be poor at forecasting these changes at turning points; At a forward SPX P/E of 15-16, the market is certainly not terribly expensive -- but its hardly cheap, either. I would call it fairly valued.

Keep in mind that forward earnings projections are merely opinions; If they turn out to be too optimistic -- and we have already seen some hints that perhaps they are -- then the market can suddenly become more expensive in a hurry.

That means the risks to the downside are increasing . . .

Tuesday, July 11, 2006 | 07:10 AM | Permalink | Comments (16) | TrackBack (1)
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Comments

The bulls have been counting on corporate earnings growth to bail them out. Frankly I don't see it happening. Any company that has missed on revenues, EPS, or disappointing forward guidance has been sold off in a hurry. It's going to take some near perfect earnings results to save this market, and those might already be priced it.

I'm sure alot of bulls have been shocked by MMM's announcement seeing that 3M has been one of the more solid companies in the Dow tracing back to 1987. A lot of bulls were also counting on Alcoa to beat the street estimates. That didn't happen, and I'm sure the whisper number was higher. That's probably why it sold off yesterday after earnings came out.

Posted by: Dave | Jul 11, 2006 9:10:15 AM