It’s been a rough ride for stock market investors lately, but you might want to get used to it. This earning season will bring a lot more.
Many investors expect the fourth-quarter earnings season to stabilize the market and bring back the bulls. They will be disappointed.
To be sure, a strong economy and consumer spending suggest a good earnings season, which is now starting. So, yes, companies will outperform total earnings. The problem is, they won’t post anything like the 9% beat of the third quarter.
Bank of America strategist Savita Subramaniam expects a 3% beat based on a subtle quantitative analysis done by her and her team. (Highlights below.) In my view, this will not be enough to stabilize the market.
What’s more, she thinks Wall Street analysts’ 2022 profit margin estimates are too high, and they’ll be laying off based on fourth-quarter results. This will also reduce the enthusiasm of investors.
One issue is that analysts have high expectations for the consumer-discretionary and industrial sectors in 2022. But those are the two most labor-intensive sectors, she notes. Labor costs rose sharply in the fourth quarter and could remain high. Companies are also impacting additional shipping and fuel costs.
Here are three key reasons why you shouldn’t be overly concerned about this earnings season, yet followed three areas and three stocks to consider when it’s favorable.
1. Early Signs Are Unfavourable
One way to read up on what will happen is to look at Beginner Journalists. According to Subramaniam and his team, there is a 71% correlation between how early reporters do and the entire earning season.
Tuesday (January 11), up to 19 S&P 500 SPX,
companies had informed. Only 53% outperformed on earnings, far below 67% from the previous quarter and an average of 69% since 2012. The companies exceeded estimates by an average of 4.2%, well below the third quarter’s 9% overall beat.
2. Executives Aren’t Happy Campers
Analysts have done a good job of using the “content analysis” of earnings call transcripts to gauge the mood of top executives. They use software to count the number of positive and negative words. Examples of positive words include: accomplish, achieve and outperform, while negatives include abandon, abnormal and bearish. (If you want to learn more about this, check out the research of Tim Loughren and Bill McDonald, who developed a dictionary of key words to count in company reports and earnings calls.)
Result: Sentiment on recent calls has dropped to its lowest level since Q3 2020. This score is highly predictive of earnings growth for the coming quarter. The dark mood indicates good, but slow, earnings growth ahead. This content analysis predicts earnings growth of 14% year-over-year, but the consensus is for Wall Street analyst estimates for 20% growth. If this is true, it will come as a negative surprise and create instability.
3. Guidance is lacking
Another trick for forecasting the upcoming quarter is to measure how corporate guidance is evolving. Here, you can track two things: 1. The number of companies guiding guidance versus prior estimates. 2. How much is the entire sell-side analyst community changing earnings estimates. Both measures suggest relative softness in the release of fourth quarter results.
Details: The ratio of up versus down guidance over the past three months was just 1.2 in December, compared to a peak of 4.5 last May. The ratio of up versus down estimate revisions made by analysts fell to 1.4 in December, from a peak of 2.9 in August.
One troubling guidance trend that isn’t on the charts: Guidance on capital spending has fallen below its historical average. This is not good, as many economists are relying on higher capital expenditure investments to improve the economy and increase productivity. The increase in productivity is expected to ease inflationary pressures. This is because companies feel less need to pass along cost increases when they are getting more from workers (the definition of high productivity). But the capital expenditure guidance suggests we may not get that relief on the inflation front.
Areas and groups for the side
This is not all serious news. There are closing earnings estimates for small-cap and mid-cap companies, as you can see in this chart from Ed Yardeni at Yardeni Research:
Analysts expect small-cap earnings and sales to grow between 25% and 17% year-on-year, says Subramanian. They expect 28% and 19% growth in mid-cap earnings and sales.
Not only this, investors seem to be ignoring this trend. We know this because small-cap and mid-cap names are undervalued compared to large companies.
Here you can see that historically the price of small-caps is really cheap as compared to larger companies. And they trade around their own historical valuation levels, so they don’t look expensive in that sense either.
Below, you can see that while mid-cap stocks trade cheaper than large-cap stocks, they are expensive compared to their own historical levels.
When hunting for stocks, you may want to favor names in real estate, energy and banking because they have the strongest upward guidance and correction in earnings and sales.
“Historically, areas with strong earnings per share and sales revisions and guidance have more earnings potential than misses in the subsequent earnings season,” Subramanian says.
Another factor to watch for is the high ratio of positive to negative surprises in the previous quarter – trends that tend to persist into the next quarter. These three groups pass muster here as well.
Three stocks to consider
To isolate the names of names whose stocks might outperform this earnings season and later, Bank of America looked to this trifecta.
1. They beat last quarter’s projections, which suggests they may happen again.
2. Bank of America analysts’ estimates are above consensus, which may suggest that consensus is very low and therefore would be a positive surprise.
3. The company is owned by active managers relative to its benchmark, which suggests that they may scramble to increase their position if a stock starts to move, to avoid underperforming.
Of the 13 companies that fit the bill, three are Marathon Petroleum MPC,
In Energy, Best Buy BBY,
In retail and synchronous financial SYFs,
in consumer finance.
Michael Brush is a columnist for Businesshala. At the time of publication, he had no position in any of the stocks mentioned in this column. Brush suggests MPC in his stock newsletter, brush up on stock, Follow him on Twitter @mbrushstocks.