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Market View

While overall earnings look set to decrease for a fifth consecutive quarter, a number of trends suggest some “green shoots” for the profit outlook.

As widely expected, earnings of U.S. companies continued their downtrend in the second quarter of 2016. According to data from FactSet, with 63% of the companies in the S&P 500® Index having reported results as of July 29, blended earnings (which combines actual results for companies that have reported and estimated results for companies that have yet to report) for the index were down 3.8%, year over year.  This puts the index on track for a fifth consecutive quarter of year-over-year declines—the first time it has recorded five consecutive down quarters since the period from the third quarter of 2008 through the third quarter of 2009.

And though there are signs that the pace of U.S. earnings declines is slowing, concerns linger. According to a Wall Street Journal report, company executives said during second-quarter earnings conference calls that they are worried about “slowing industrial production and a tumultuous political climate.”1

It’s important for equity investors to keep that caution in perspective. In the April 4th Market View, we examined the prospects for the U.S. first-quarter earnings season. Our conclusion was that investor pessimism about corporate profits (which were set to post their fourth straight quarter of decline) may have been overdone. As we noted last time, it’s important to keep in mind that all markets are, in effect, expectation-discounting mechanisms. In other words, market participants factor in current profit weakness, and later focus on the prospects for coming quarters. We’ve written about this topic before, noting that the market can do well when earnings decline.

And the market’s recent experience has proved that point, with U.S. stocks holding their own as investors continue to turn to equities in the face of low yields from other investments. Stronger-than-estimated earnings results and expectations that central banks will continue their stimulative policies also have lent support. Indeed, since the publication of the April 4th Market View, the S&P 500 has gained 4.7% (through August 4), according to Bloomberg.

Now here we are, with another earnings season largely completed. What then should investors be focusing on as the second-quarter picture comes into full view? What follows are, we believe, five important insights from the second-quarter U.S. earnings season (based on results through July 29).

1) Earnings, though lower, have topped analyst expectations.
Reported earnings for the second quarter of 2016 showed improvement from the first three months, with 71% of the companies posting earnings above the mean estimate of securities analysts and 57% topping revenue expectations. According to a BofA Merrill Lynch report released on August 1, better-than-expected earnings from the technology sector, particularly Internet companies, helped earnings per share come in 2% better than analysts expected at the start of July. The report noted that results from banking, software, capital markets, and Internet software and services companies have been the biggest drivers of the outperformance, while aerospace and defense, oil and gas, and insurance firms were the biggest detractors.

2) Sector performance remains mixed, with energy continuing to lag.
By far, the greatest declines in the second quarter have come from the energy and materials sectors (as Chart 1 shows). Results for other S&P 500 sectors were mixed. However, on a sector-by-sector basis, the rate of change, in terms of reported numbers versus expectations at the start of earnings season, has largely been improving.


Chart 1. Energy Has Fueled the U.S. Earnings Slowdown
S&P 500 sector earnings growth rates for the second quarter of 2016

Source: FactSet. Data are as of July 29, 2016, and reflect reported numbers as of July 29 versus analysts’ expectations prior to the start of second-quarter reporting season. The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
Past performance is no guarantee of future results.

 

3) Revenue growth may have turned the corner.
At the beginning of July, revenues for S&P 500 companies were expected to decline 0.8% in the second quarter, according to FactSet. But Chart 2 shows another “green shoot”: blended revenue growth in the second quarter actually turned positive, albeit barely. If the index reports growth in revenues for the quarter, it will mark the first time the index has seen year-over-year growth in sales since the fourth quarter of 2014.

 

Chart 2. After Five Down Quarters, U.S. Companies’ Revenue Growth Nudges into Positive Territory
S&P 500 sector revenue growth rates by quarter, 2014–16

Source: FactSet. Data as of July 29, 2016. The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
Past performance is no guarantee of future results. 

 

There are other encouraging developments at the sector level, according to FactSet. Through July 29, six of the 10 S&P 500 sectors had reported revenues above estimates by 1.2% or more for the second quarter.

4) Major headwinds appear to be abating.
Some big factors that have hurt U.S. corporate profitability over the past few quarters appear to be lessening. Despite recent declines, crude oil prices remain above earlier lows and have traded in a stable range. As Joseph M. Graham, Lord Abbett Investment Strategist, notes, energy and materials price weakness has not had a significant negative impact on rest of the market, with the significant drop-off in net profit margins in energy not evident in other sectors.

U.S. dollar appreciation has been an additional headwind for domestic earnings. Even though the dollar has rallied modestly since April, it still is in a relatively tight range over the last 18 months. That stability removes a major headwind to U.S. multinational earnings, which dominate headline earnings numbers. Indeed, the effect can be seen in Chart 3, which shows a lessening negative currency impact on year-over-year sales growth in the second quarter.

 

Chart 3. Currency Impact on Sales Growth Continued to Fade in the Second Quarter
Estimated currency impact (%) to S&P 500 quarterly year-over-year sales growth

Source: FactSet and BofA Merrill Lynch U.S. Equity & U.S. Quant Strategy. Data as of August 1, 2016. The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
Past performance is no guarantee of future results. 

 

As Graham pointed out in the April 4th Market View, “As we ‘lap’ the U.S. dollar strength—meaning that we are past 12 months from the end of the rise—the pressures from a rising dollar on year-over-year earnings will lessen.”

To be sure, U.S. companies still face significant challenges as they try to bolster profitability. But with these impediments to profit growth diminishing, analysts expect earnings to be positive by the fourth quarter of 2016. “This brighter outlook reflects expectations of continued stabilization in the U.S. dollar as well as the limited impact of commodity weakness on the broader economy,” says Graham.

5) Equity investors may wish to get selective.
Where does this leave stocks? The S&P 500 is trading at around 18 times this year’s projected earnings, and is near its highest multiple in more than a decade, notes the Journal report. Forward multiples are notoriously poor predictors of near-term market direction, but we acknowledge that investors will need to be more selective going forward.  Further, we believe that there are three distinct pockets of opportunity in equities:

  • Select growth equities— We believe that for long-term investors, high-growth investing has become more essential for investment success. Within the broad market, there are powerful organic growth themes as well as continuously evolving areas of “creative destruction,” whereby innovation transforms an industry. Innovation in secular growth industries, such as biotechnology, cloud software, and e-commerce, continues to thrive, fundamentally speaking, despite a sluggish U.S. economy. 
  • U.S. consumer-oriented stocksDespite the slow growth of gross domestic product (GDP), the U.S. consumer has demonstrated resilience.  With monthly employment data showing continued strength in the labor market, U.S. GDP—of which nearly 70% is driven by consumer spending—could get an additional lift.  How might equity investors benefit from this trend? By considering U.S. small- and mid-cap companies, which tend to be more domestically focused than larger firms. Based on data from FactSet, small-cap companies, for example, derived nearly 75% of their revenue from the United States in fiscal 2015, based on fiscal-year 2015 revenue estimates compiled by FactSet, while mid-cap companies garnered around 68%. By contrast, large-cap companies derived 58%.
  • Dividend-paying stocksOn top of an income stream that was recently higher than what could be found in many fixed-income markets, and the potential for a growing income stream, dividend-paying stocks also have provided principal growth potential. In addition, U.S. dividend-paying stocks historically have provided higher returns with less risk than stocks that do not pay a dividend. Thus, dividend-paying stocks may be an attractive way to reduce the volatility of investors’ equity allocations, in addition to the attractive income and appreciation potential.

 

1Theo Francis and Kate Linebaugh, “Anxiety Weighs on U.S. Corporate Earnings,” The Wall Street Journal, August 2, 2016.

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