Will Earnings Stop The Bleeding?

1/18/2016


The Dow Industrials suffered their worst start to a new year in their history, with worries regarding China and U.S. corporate profits receiving much of the blame. While the outlook for China will be debated throughout 2016, expect profits to dominate the discussion over the next few weeks.

For now, with the Dow Theory in the bearish camp, a somewhat cautious approach is warranted. As a partial hedge, our buy lists have 21% to 24% in a short-term bond fund. Depending on the reaction to earnings season, we may adjust our equity exposure again in coming weeks.

Broad-based weakness

Fourth-quarter earnings season begins with the average U.S. stock down more than 10% since Dec. 29, investor sentiment unusually pessimistic, and expectations for quarterly results subdued.

Per-share earnings for the S&P 500 Index are expected to be down 5% from the year-earlier quarter, according to FactSet. A 1% decline was expected on Sept. 30, but since then expectations for nine of the index's 10 sectors have weakened.

Another year-to-year decline for the fourth quarter would mark the first time since 2009 that the index has seen three consecutive quarterly declines. Revenue is expected to be down 4%, the fourth consecutive decline.

Even excluding the hard-hit energy sector, earnings are expected to be even with the year-earlier period, says FactSet. Revenue is expected to be up 1% excluding energy. Six of 10 sectors probably suffered earnings declines, while four are expected to post lower revenue.

Looking for clarity

For the large, midsized, and small stocks in the S&P 1500 Index, average and median trailing P/E ratios are in line or slightly below 20-year norms. But the median S&P 1500 company reported growth of just 3% for per-share profits and 2% for sales in the most recent quarter, numbers likely to worsen once December-quarter results are announced.

Without some improvement in the outlook for profit growth, stocks are likely to struggle — even if valuations appear attractive relative to current bond yields. However, investors won't wait for profit comparisons to turn positive before reacting. With even a little clarity on how profit growth will rebound, stocks could bounce sharply.

While a positive reaction to quarterly results and 2016 guidance would be encouraging, at this point we probably wouldn't lower our cash position on a rally. A failure to bounce on earnings would give us a reason to raise cash, especially if some of the growers on our buy lists stumble.


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