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Weekend Wisdom

You have seen the headlines - stocks are at all-time highs.

Reasonable people can disagree over what matters more to the stock market, but no one can deny the centrality of earnings to stocks. Some even go to the extent of calling earnings the 'mother's milk' of stock prices.

So, if stocks are doing this good, then earnings must be in very good shape. But are they?

My answer is: No. The market is pricing in a very optimistic view of earnings that is unlikely to play out.

Earnings have been essentially flat over the last three quarters, and investors expect this trend to continue into the first half of 2013. But growth is expected to come roaring back in the second half of the year and continue into 2014.

I don't think it's going to pan out like this and want to share the basis for my skepticism with you in this write-up. I am by no means suggesting an earnings train wreck on the horizon or a call to exit the market altogether. What I am suggesting instead is that current earnings expectations are vulnerable to significant downward revisions. And an acceleration in that negative revisions process will most likely result in the market giving back some, if not all, of its recent gains.

You don't have to agree with my conclusions. But it would nevertheless pay to be a little skeptical of current earnings expectations, take another look at your portfolio and perhaps reposition it for an extended period of weakness.

More . . .

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The discussion is particularly timely with the Q4 earnings season giving investors a misleading sense of security about the earnings picture. My goal in this write-up is to give you an update on how the Q4 earnings season turned out and what recent estimate revisions trends tell us about the future of earnings growth.


Was the Q4 Earnings Season That Good?

On most conventional measures, the Q4 earnings season turned out to be good enough - not great, but not bad either.

But the market is happy with what it saw in Q4 earnings. A major reason - expectations. They fell enough in the run up to the reporting season that coming ahead of them proved to be fairly easy. This shows that earnings growth turned out to be better relative to expectations immediately before the reporting season started (early January), but significantly lower compared to expectations in early October.

That said, the Q4 growth rates are better than the third quarter, but are significantly lower compared to the average of the preceding four quarters.


Expectations for the Coming Quarters

Ever since the Q4 earnings season got underway, analysts have been cutting their estimates for the first quarter of 2013. Driving this trend has been management guidance, which was relatively less negative this time compared to the quarter before, but was nevertheless predominantly on the weak side.

The table below provides the expected earnings growth rates and what we got in the preceding quarter and year.

Instead of growth rates, take a look at the absolute dollar levels of earnings in the chart below - for 8 quarters (four actual and four expected) and 7 years (five actual and two expected).

What we can see from this data is that earnings essentially flat-lined over the last three quarters, but are expected to bottom in the current quarter. And then start going up - in a big way.

Expectations are for flat earnings growth (up only +0.3%) in the first half of the year, but a ramp up in the back half to a growth pace of +10.2%. This growth momentum is expected to carry into 2014, giving us earnings growth of +11.7% that year after the +6.8% gain in 2013 and +3.8% growth in 2012.


How Realistic Are These Expectations?

I don't think these expectations will pan out. And here is why.

Earnings increase through two ways: revenue growth and/or margin expansion. And the outlook on both fronts is problematic. Margins have peaked already and at best can be expected to stabilize around current levels. And you can't have significant revenue growth in the current growth-constrained environment.

The U.S. economy is actually in better shape relative to the recession in Europe and Japan's efforts to inflate away its problems. But that's only in relative terms - the reality is that the U.S. economy is at best on a sub-2% growth trajectory. And even that growth pace may be at risk from the unfolding fiscal austerity. But consensus expectations are looking for a second-half 2013 GDP growth ramp that pushes the growth pace close to 3%. With the U.S. economy barely producing any growth in the fourth quarter, it is hard to envision the growth outlook improving to that extent.

Margins follow a cyclical pattern. They expand as the economy comes out of a recession, then stabilize, and eventually start coming down as capacity constraints force spending more for incremental business. I don't agree with those that are looking for margins to start contracting, but I can't see margins expanding either.


So What Gives?

Not only are margins already at record levels, but corporate earnings as a share of GDP are also at multi-decade highs. Just like trees don't grow to the skies, margins and the ratio of earnings to GDP don't expand forever either.

What all of this boils down to is that current earnings estimates are high and they need to come down - and come down quite a bit. One could reasonably draw a scenario where earnings growth could turn negative this year. But the most likely path appears to be for earnings growth to flatten out - with the absolute level of earnings this year and next not much different from what we got in 2012.


Investing in a Low Earnings Growth Environment

The bottom line is that actual earnings growth will be substantially lower than what is currently imbedded in stocks prices. This view is contrary to current consensus expectations and could potentially serve as a major headwind for the market once it takes effect in the coming months.

The way to invest in such an environment is to look for stocks that don't reflect aggressive growth expectations and enjoy company-specific growth drivers not tied to broader macro trends. Companies that generate plenty of cash flows beyond their immediate capital needs and have track records of sharing excess cash with shareholders through dividends and buybacks are particularly well suited for a period of sub-par earnings growth environment. Bottom line, look for thematic stocks with strong defensive attributes.

Today, I invite you to consider two such stocks which I explain in an article I prepared exclusively for Zacks Confidential. This weekly service highlights what our Executive Vice President Steve Reitmester selects as the most timely and promising of Zacks' recommendations.

These two stocks are primed to outperform regardless of how the macro earnings picture evolves. One is a company that has unusually strong free cash flow prospects and is likely to deploy them in a very shareholder-friendly manner. The other seems to go against conventional wisdom, but its near-monopoly should result in growing dividends for years to come.

Look into Zacks Confidential now >>

Best,

Sheraz Mian

Sheraz Mian is the Director of Research for Zacks and manages our award-winning Focus List portfolio. He names two key investment opportunities in the latest edition of Zacks Confidential.

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