Will Earnings Season End the Rally?
04/10/2012 8:30 am EST
Alcoa’s profit reports kicks off what promises to be a challenging season. Here’s what to watch for from a few key companies—and how to come up with a game plan, writes MoneyShow’s Jim Jubak, also of Jubak’s Picks.
Everybody "knows" that first-quarter earnings growth for US stocks will be anemic. The projection for year-to-year earnings growth on S&P 500 stocks is just 0.93%, according to Standard & Poor’s Capital IQ. That compares with 19.68% earnings growth in the first quarter of 2011.
Logically, this means stocks are headed for a correction as companies report their first-quarter results beginning with Alcoa (AA) on Tuesday. "Logically," that is, for realms outside the stock market.
In the logic of the stock market, however, the result is by no means certain. What "everyone knows" is frequently already accounted for in share prices. But sometimes, what everyone knows isn’t really believed by investors.
Intellectually, investors may know that projections for first-quarter earnings growth are extremely low. But in their hearts—and in their investment actions—they may remain much more optimistic.
And, anyway, the earnings results of last quarter are history. For stock prices going forward, the important numbers are companies’ projections—guidance—for the second quarter and the rest of 2012. Expectations for future growth are what make investors buy or sell.
So what will it be—up or down?—for the market this earnings season? And what strategy do I recommend?
I wouldn’t recommend any big directional bet on the market as a whole—I think the uncertainties are too high. But I would like to be sitting on some cash.
(My Jubak’s Picks portfolio finished 2011 with almost 40% in cash, and, despite some recent buys, I’ve still got a hefty cash position. So do you, if you did some selective selling into the rally. Otherwise, you might need to do some selective selling now to be ready for investing opportunities.)
I want to be ready to jump on any sell-off because of a short-term disappointment in a stock I’d like to own for the long term. The second half of 2012 looks better in global macroeconomic terms than the first half of the year, and I’d love to pick up some fundamentally strong long-term buys at temporarily depressed prices.
So let me explain how I calculate the risks and uncertainties of this first-quarter earnings season.
Hope Falls Fast
The current projection of just 0.93% year-to-year earnings growth doesn’t capture how rapidly pessimism about earnings in the first quarter has set in.
In September, Wall Street was looking for 10% growth in the first quarter. By January, projections were down to 4.5%, according to S&P Capital IQ. And now we’re at 0.93% with the quarter done and earnings reports set to start arriving.
For the first quarter of 2012, earnings per S&P 500 share are projected at $23.85. In the first quarter of 2011, earnings per index share came in at $23.63.
Of course, the S&P 500 Index finished the first quarter of 2012 at 1,408.47, up from 1,325.83 on March 31, 2011. The index is thus 6.23% higher than it was a year ago, even though growth in the quarter just completed is projected as 18.75 percentage points lower than in the first quarter of 2011.
Add in the sentiment and macroeconomic background, and it looks as if we’re headed for an almost-certain sell-off. This rally was up 28.1% from the October 3 low through March 31. Many investors are sitting on big profits—exactly the situation that leads to profit-taking as sellers decide to protect their gains.
After the disappointing jobs number for March—just 120,000 new jobs when the market was looking for 205,000—voices calling the market overbought and in need of a correction have gained in number and volume.
Sinking Spanish and Italian bond prices—and rising yields on Spanish and Italian bonds—have raised fears that the Eurozone is facing another round of its apparently never-ending debt crisis.
Higher-than-expected inflation from China in March—a 3.6% annual rate, instead of the 3.4% expected by economists—was announced over the weekend, increasing worries about growth in that economy. These factors certainly haven’t helped.
I think that meager first-quarter earnings growth, against a background of macroeconomic worries and sentiment looking for a correction, is likely to produce a drop in market indexes.
But I don’t think that’s by any means as certain as a backward-looking analysis of the market and the economy would suggest. Guidance for the second quarter and the rest of 2012 will be key.
Case Study in Aluminum
Let’s use Alcoa, which reports Tuesday, as an example. Even if you don’t care a penny about Alcoa, the stock is a perfect template for how the earnings season is likely to play out.
The consensus among Wall Street analysts is that Alcoa will report a first-quarter loss of 3 cents a share. That would match the loss of 3 cents a share, after one-time items, for the fourth quarter, but it would represent a big drop from the 28 cents a share recorded in the first quarter of 2011.
The earnings pattern here isn’t encouraging. From 32 cents per share in the quarter ended in June, earnings at Alcoa have dropped to 14 cents in the third quarter to a 3-cent-per-share loss in the fourth quarter.
Analysts have cut their projections for the first quarter from ten cents a share 90 days ago to the current consensus of another 3-cents-a-share loss. The spread isn’t encouraging, either, with a high analyst estimate of 7 cents per share to a low estimate of an 11-cent-per-share loss.
All that information is already out there, and is part of the reason shares have fallen 9.2% from March 19, the March high, to the April 6 close.
Nobody is going to be surprised if Alcoa reports a loss. But the stock might drop if some of the folks who currently hold the shares are among the optimists hoping for 7 cents a share and decide to sell on a report of a loss.
The surprise might indeed be if Alcoa beats the estimates by a penny or two. That might push the shares up in after-hours trading.
But the make-or-break on the shares, the thing that might make them move up or down substantially—and that might actually generate a trend in the stock that might last more than a day or two—is what Alcoa says about the second quarter and the rest of 2012.
When the company reported fourth-quarter earnings in January, it said it expected aluminum consumption to grow by 7% in 2012, down from 10% growth in 2011. According to the company, China would continue to grow faster than the global economy as a whole, at 12%.
The decline from 10% growth in 2011 to 7% growth in 2012 wasn’t quite as disheartening as it sounded. The company was looking for a drop in global production that would support aluminum prices, as about 1.1 million metric tons of production in China went idle and the rest of the world kicked in an additional 700,000 tons of curtailments.
But it wasn’t exactly good news, either, because 531,000 metric tons of that global curtailment would come from Alcoa itself. The company confirmed those cuts, announced in January, on April 5.
And that’s where we stand. I think what the stock market wants to hear from Alcoa isn’t whether first-quarter earnings were a few pennies lost or gained but what the company now projects as global demand growth—is it still 7%?—and its projection of demand growth from China—is it still 12%?—for the rest of 2012. That will drive the trend in the stock.
Look to the Future
You can do the same kind of analysis with stocks that you probably care about more than you do Alcoa.
McDonald’s (MCD), for example, is scheduled to report on April 20. The stock is coming off its first comparable-store sales miss in months in February. Comparable sales climbed 7.5%, while Wall Street was looking for 8.3%.
Analyst earnings estimates are rock-solid: At $1.23 a share for the first quarter, they haven’t changed more than a penny in the past 90 days. But Wall Street is looking for just 6.84% year-on-year growth in the quarter. That would be a big drop from the 15% year-on-year growth recorded in the fourth quarter.
In the past couple of quarters, McDonald’s has turned in a modest positive surprise—2 cents better than expected in the quarter ended in September, and 3 cents better in the quarter ended in December.
So, anything less than a few cents above $1.23 a share might be considered a miss—and confirmation that slow economies in Europe and Japan, and a slowing economy in China, are about to cut into the company’s growth rate.
It won’t be fair, but investors could also decide to sell if McDonald’s shows a bit of weakness because longtime CEO Jim Skinner is retiring in June. His replacement is 22-year McDonald’s veteran and current Chief Operating Officer Don Thompson.
If McDonald’s shows a bit of earnings weakness this quarter, some investors nervous about the CEO transition might sell. If I could buy McDonald’s at $95 on any of this quarterly earnings noise, I would, with a 12-month target of $110.
You might also want to keep an eye on Arcos Dorados Holding (ARCO), the largest McDonald’s franchise operator in Latin America, if McDonald’s shares themselves dip. The stock is down 29% since I added it to my watch list on August 16, 2011, but I see some signs that the price—$18.48 at the close on April 6—might be starting to stabilize. The company itself doesn’t report first-quarter earnings until May 5.
Or, how about Schlumberger (SLB)? Wall Street analysts are looking for first-quarter earnings of 99 cents a share, a huge 39.7% jump from the first quarter of 2011.
But the consensus conceals a high degree of worry. The trend in estimates has been decidedly negative over the past 90 days, going from $1.08 to 99 cents a share in that time. The worry is North America, where continued low natural gas prices have caused gas producers to shut wells and curtail exploration and drilling operations.
As I wrote in my March 28 post on Schlumberger, the company has acknowledged the slowdown in North America, the source of 33% of its revenues, and said that it won’t be a one- or two-quarter problem. Investors will be waiting to hear, when Schlumberger reports earnings April 20, how big a problem the North American slowdown is.
The company hasn’t been a model of consistency recently, reporting an earnings miss for the third quarter and a positive surprise in the fourth. As I wrote in that post, I’d be a buyer on a pullback to $64 or $65 from the $68.42 close on April 6.
And finally, don’t ignore the chance to add to positions in stocks you already own on unjustified weakness this quarter. (Or to sell if the weakness is justified.)
For example, Cummins (CMI), a Jubak’s Pick, reports earnings on May 1. The stock has been volatile lately on news of an 11% drop in orders for Class 8 trucks, the big rigs, at North American manufacturers. This is the third consecutive month-to-month drop in Class 8 orders.
The March numbers were 32% below the level of March 2011. Investors will want to find out from Cummins whether this is a sign that the truck cycle, which most of us believe still has upside ahead, is coming to an unexpected slowdown.
Cummins has already shocked investors in recent quarters with an earnings miss (granted, it was just 5 cents a share) in the quarter ended September 2011. The truck-engine maker came roaring back with a 15.8% positive surprise for the quarter that ended in December, but the $2.19 per share consensus projection conceals a high degree of disagreement, with the top estimates at $2.42 and the bottom at $1.99.
With 60% of Cummins sales coming from outside the United States, I think it’s hard to predict what the slowdown in Europe and China will do to Cummins revenue. I’d look to add to positions on a drop in sales and earnings from those regions, as long as the company convincingly testifies to the continuation of the truck cycle.
I’m sure you have your own list of stocks to watch this earnings season, but let me add one: Middleby (MIDD).
This maker of cooking equipment for fast-food and casual-dining restaurants has been a member of Jubak’s Picks before, and I’d be happy to return it to the portfolio if this earnings season gives me an opportunity. I’m adding it to my watch list with this column.
Now, let the earnings season begin!