We entered the second-quarter earnings reporting season with Wall Street analysts expecting the worst results in almost six years. But those expectations were unnecessarily low, and I believe that better-than-expected quarterly earnings will be a catalyst to drive US stock prices even higher.
When the earnings reporting season kicked off in mid-July, analysts were forecasting a 4.3% year-over-year drop in S&P 500 operating earnings, which would have marked the first drop in earnings per share (EPS) since the third quarter of 2009.1 But that gloomy forecast was overdone and as we head into the final stretch of the reporting season, here are four reasons why second-quarter earnings have outperformed Wall Street’s expectations:
- Analysts’ EPS estimates are often guided by companies, which tend to under-promise and over-deliver when it comes to estimates. That means it’s a fairly regular occurrence for earnings results to beat Wall Street estimates. In addition, while it’s a common practice for analysts to lower estimates headed into an earnings season, the size of the reductions being made by analysts this reporting season were lower than the 1-year, 5-year and 10-year average.2 That was a good sign for the quarter.
- Digging deeper, you’ll find that the second quarter’s negative expectations were largely traced to one sector—Energy. Analysts expected EPS at energy companies to fall upwards of 60% year-over-year due to the massive drop in oil prices.3 But oil prices rebounded from mid-April through much of the second quarter, and if energy companies were excluded from analysts’ estimates, S&P operating EPS were expected to increase 4 percent.4
- The US dollar was also to blame for poor second-quarter EPS estimates. Analysts worried that the strong US dollar would hurt large, multi-national companies that generate a significant amount of revenue from outside the United States. But the US dollar hit a plateau from mid-April through the end of the second quarter, meaning dollar-related headwinds did not hurt corporations as much as analysts were expecting.
- While the Energy sector was forecast to struggle, numerous market sectors, including Health Care, Financials, Consumer Discretionary and Information Technology, were expected to have healthy year-over-year earnings growth. Last year, those sectors accounted for close to 60% of the S&P 500’s earnings.5 This far outweighs Energy, which accounts for roughly 11% of the S&P 500’s earnings.6 As of August 10th, about 90% of S&P 500 companies have reported second-quarter results.7 Of those, 50% have reported positive sales surprises, while about 75% have posted positive earnings surprises. In fact, Energy, Health Care, Financials and Information Technology have all beat sales and earnings estimates for the second quarter.8
Halfway through the third quarter, we’ve seen oil prices decline and the US dollar has begun to climb again. But the volatility and uncertainty produced by geopolitical events like Greece are fading from headlines, and investors can once again focus on market fundamentals.
Given the four reasons above, earnings from Energy companies and large, multi-nationals were not as bad as Wall Street anticipated, resulting in healthy earnings for the second quarter. These earnings are indicative of a US economy that continues to recover and gain traction, setting the stage for potentially higher US stock prices as well as an environment in which the Federal Reserve may feel comfortable raising interest rates.
Investors could be well served to seek out sectors of the market that will benefit from higher interest rates, including Financials, Banks and Regional Banks.
1S&P Capital IQ, as of 7/31/2015
2FactSet Insight, as of 7/31/2015
3S&P Capital IQ, as of 7/31/2015
4S&P Capital IQ, as of 7/31/2015
5Strategas Research Partners, as of 7/31/2015
6Strategas Research Partners, as of 7/31/2015
7Bloomberg, as of 8/10/2015
8Bloomberg, as of 8/10/2015
This article was written by Michael Arone, CFA, Managing Director of State Street Global Advisors and the Chief Investment Strategist for the US Intermediary Business Group.