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September 15, 2016

Idea of the Week: Q3 Fundamentals May be Stronger than They Appear

by Greg Harrison.

The third quarter earnings season is looming, and analysts are projecting a fifth consecutive quarter of declining earnings for the companies in the S&P 500 index, with overall earnings expected to fall 0.9%. Revenue is expected to break its streak of six straight quarters of declines, with an increase of 2.3%. As seen below in Exhibit 1, the EPS growth estimate has fallen 2.9 percentage points since the beginning of the third quarter. Only one sector, Information Technology, has seen its EPS growth estimate rise over this period.

Exhibit 1.  S&P 500: Q3 2016 Earnings Growth Estimate & Change Since July 1


Although analysts are not especially bullish on Q3 earnings, there are some signs that the quarter could be better than expected. In a typical quarter, the EPS growth estimate falls 4.0 percentage points. As we near the end of the calendar quarter, the growth rate has fallen by only 2.9 percentage points, so the bearish analyst sentiment is actually slightly stronger than it may otherwise be.

In addition to analyst sentiment, management teams are more optimistic about Q3 results than they have been in several years. The ratio of negative to positive preannouncements for Q3 stands at 2.2. As seen below in Exhibit 2, this is the lowest this ratio has been in over five years. Even though there is still more negative guidance than positive, the extreme pessimism that company management teams exhibited relative to the analysts covering their companies has abated.

Exhibit 2.  S&P 500: Negative to Positive Earnings Guidance Ratio Trend


Top line revenue is also showing more positive signs in Q3, with S&P 500 companies expected to grow sales 2.2%. This would be the first quarter of revenue growth since Q4 2014. When it comes to revenue, company issued guidance is also significantly stronger than usual, with a negative to positive guidance ratio of 1.1, well below the historical average of 1.8. Exhibit 3, below, shows this trend of optimistic sales guidance, as Q3 will be the most positive quarter in five years, since Q3 2011.

Exhibit 3.  S&P 500: Negative to Positive Revenue Guidance Ratio Trend


When looking at the improved guidance and analyst outlooks, we see similar sectors driving the trends. In particular, the Information Technology sector has had 17 negative EPS preannouncements and nearly as many positive, at 16. In terms of revenue, technology managers have been even more optimistic about meeting analyst forecasts, with 18 negative revenue preannouncements and 25 positive. This parallels the trend in analyst forecasts for the sector, where technology is the only sector to have its EPS growth estimate increase throughout the quarter. Companies in the sector are expected to benefit from increased corporate IT spending as well as a new hardware cycle for processors and memory.

In addition to tech, we also see Utilities and Consumer Staples looking stronger than average in terms of both analyst revisions throughout the quarter and company issued guidance. Utilities continue to benefit from low energy prices, while increasing consumer confidence is helping companies in Consumer Staples.

Exhibit 4.  S&P 500: Q3 2016 Negative to Positive Earnings Guidance Ratio by Sector


Looking beyond Q3, the fundamentals picture improves further, with analysts projecting earnings to begin growing again. The Energy sector is expected to be the main driver, as year over year comparisons become favorable in Q4. Companies in the Energy sector tend not to provide guidance, as their results are so heavily dependent on oil prices, so analyst forecasts will be the primary basis for judging expectations. However, with the big declines in earnings for the sector over the past two years, it is now a smaller portion of the index and overall earnings expectations will be driven more by some of the positive trends in the economy, like the resurgence of tech and improvements in consumer spending.



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