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Earnings Preview

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The market was looking for clarity from the Fed about the future of the QE program. But it didn’t like the surprisingly explicit timeline from Chairman Bernanke, and has been in a somewhat downbeat mood ever since.

The after-effects of the Bernanke announcement and the resultant impact on benchmark interest rates will no doubt remain the big issues for the market this week as well, but we are also getting close to the start of the Q2 earnings season. In fact, the Q2 earnings season actually got underway last week with the earning releases from FedEx (FDX - Analyst Report), Oracle (ORCL - Analyst Report), Adobe (ADBE), Darden (DRI - Analyst Report) and others.

It hasn’t been a very inspiring start thus far, but all of these companies have been grappling with lingering issues affecting their businesses for awhile and their Q2 reports didn’t indicate that they had finally turned the corner. We will see if this week’s reports from the likes of Walgreen (WAG - Analyst Report), ConAgra (CAG), Lennar (LEN - Analyst Report), Paychex (PAYX - Snapshot Report) and others will show a more promising side of the earnings picture. But we will likely have to wait a bit longer for the reporting season to get really high gear -- Alcoa’s (AA) report is coming on July 8th.

As has become customary at the start of recent quarterly earnings cycles, expectations for the Q2 earnings season remain quite low. A major driver of these low expectations is company guidance during the Q1 earnings season, which was overwhelmingly on the negative side. Total earnings for companies in the S&P 500 are expected to be up only +0.5% from the same period last year.

This is sharply down from +3.9% growth expected in the quarter in early April. Total earnings were up +2.3% in Q1, but growth was expected to be in negative territory at this stage before that reporting season.

Finance wasn’t a big driver of aggregate earnings growth for the S&P 500 in Q1, but takes back the lead role in Q2, with total earnings for the sector expected to be up +19.6% and estimates for the group are steadily going up. Earnings for the sector were up +7.7% in Q1, which came after many quarters of double-digit growth.

All the industries within the Finance sector -- major banks, regional banks, brokers and insurers -- are expected to have positive growth. But the growth picture is particularly notable for the brokerage and investment management industry players like Goldman Sachs (GS - Analyst Report) and Morgan Stanley (MS - Analyst Report), with total earnings for the group expected to be up +39.6% in Q2 after the +2.6% gain in Q1.

Unlike Finance, the earnings picture for the Technology sector remains fairly weak. Total earnings for the sector are expected to be down -8.7% from the same period last year, which follows the -3.8% earnings decline in Q1. Earnings estimates for the sector have been steadily coming down over recent weeks, with the current -8.7% decline down from expected decline of -3.1% in mid-April.

The weakest group within the Technology sector is the PC makers, with total earnings for the Computers and Office Equipment industry expected to be down -16.1% in Q2 after the -14.1% decline in Q1. Semiconductors and electronics are other Tech industries with negative earnings growth in the quarter.

Expectations for full-years 2013 and 2014 have come down far less than what we have seen for Q2 estimates. In fact, it is reasonable to assume that given the improving outlook for the Finance sector, aggregate estimates will start rising after a very long time in the coming weeks.

The +6.1% growth in total earnings this year, down from +6.8% in early April, reflects a material ramp up in the second half of the year that is then expected to carry into 2014. Combining the actual results for Q1 with estimates for Q2 gives us +1.5% year-over-year growth in total earnings in the first half of 2013. But total earnings are expected to be up +9.4% in the second half of the year and a further +11.5% in full-year 2014.

Total earnings for companies in the S&P 500 in Q2 are expected to remain to below Q1’s record level. By our calculation, aggregate bottom-up earnings in Q2 will total $246.8 billion, compared to $245.6 billion in 2012 Q2 and 2013 Q1’s record of $253.9 billion. The Finance sector will generate $49 billion or 19.8% of the S&P 500’s total Q2 earnings, while the Tech sector is expected to generate $41.5 billion or 16.7% of the index’s total earnings.

Finance is reclaiming its dominant earnings position in the index which was taken over by the Tech sector following the 2008 crash. Tech remained the biggest earnings producer for the S&P 500 from 2008 through 2012, but the leadership role moves back to Finance this year. Finance is on track to produce $198.5 billion in 2013 (19.3% of the total), up from $173.6 billion in 2012 (17.9% of the total), while Tech is expected to produce $183.1 billion this year (17.8% of the total), up from $182.9 billion in 2012 (18.9% of the total).

Trends in Estimate Revisions

The revisions trend appears to have lost some ground in the last few weeks, though the overall trend still remains in the positive-to-neutral territory, as the charts below show. The key metric in all the charts is the ‘revisions ratio,’ which is the ratio of total number of upward revisions over the preceding four weeks to the total number of revisions (positive and negative) over that same period.

We have two charts each for 2013 and 2014. The bar charts show the current state of the ‘revisions ratio’ (as of 6/14/13), while the line charts plot the ratio’s trajectory over the preceding 24 months.

The ratio doesn’t tell you the ‘magnitude’ of the revisions, only the direction. The ‘50%’ level (the dark line) is the dividing line between positive and negative trends, with readings above 50% implying more positive than negative revisions. That said, our analysis shows that readings between 45% and 55% don’t offer material insights into the magnitude of revisions. It is only readings above 55% and below 45% that offer bullish and bearish signals about the magnitude of earnings revisions.

As you can see in the charts above, the revisions trend for the S&P 500 as a whole is still in neutral territory, the current level (49% for 2013) is down from three weeks back (56% at the end of May). Finance has been in bullish trend for weeks now, but the estimate revisions trend for the Tech sector also seems to be moving in that direction now.

Hard to tell how sustainable the trend will prove to be, but the sector’s revisions ratio for 2013 currently (as of 6/14) stands at 59.6%, the highest level in over 12 months. Some of the stand-out revisions in the sector were industry players like Motorola Solutions (MSI - Analyst Report), Advanced Micro Devices (AMD) and NetApp (NTAP).
 
Finance continues to be in bullish territory for both this year and next (the blue line). The sector’s revisions ratio currently (as of 6/14) stands at 72% for 2013 and 74% for 2014, signaling good times ahead for the sector. The trend makes perfect sense as higher interest rates may be a hindrance for other industries, but it’s beneficial for the Finance sector’s earnings.

Flat net-interest margins have been a permanent feature of the sector’s, particularly banking’s, earnings picture in recent quarters. The Finance sector’s positive earnings outlook is a function of the rising trend in interest rates.

On the negative side, the revisions trend is decidedly in bearish territory for Industrials and Basic Materials both for this year and next. Peabody Energy (BTU), U.S. Steel (X - Analyst Report), Joy Global (JOY - Analyst Report), Freeport-McMoran (FCX - Analyst Report) have all suffered significant negative estimate revisions lately.

Fed aside, we have a bunch of housing related data on deck this week, including Housing Starts and Existing Home Sales data. We will also have the Empire State and Philly Fed regional manufacturing surveys and the May CPI numbers this week. But everyone will be looking ahead to the Bernanke press conference on Wednesday afternoon.

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