A Preview of Q2 Earnings

Is Q2 the quarter where earnings disappointments impact the markets? After 14 quarters of double digit year-over-year earnings growth, is this the Q that blindsides investors? Its too early to tell, but there are quite a few warning signs to consider.

In particular, I am watching these 5 elements this earning season:

Bellwether Misses: 3M, EMC, Alcoa, Lucent — each of these firms Q issues has been spun as "specific to the company" and not a sector-wide or market issue. If these numbers rise, it becomes harder to believe the company specific mantra;

Compare the Numbers:  Corporate management is keenly aware of the big 3 issues investors watch: Revenue shortfalls, profit disappointments, weak guidance. Keep on eye on how this Q compares to prior Qs in terms of these 3 data points — especially how they compare with the past few recent Qs.

Options Options Options:  Between the option backdating scandals, and more recently, "spring-loaded options," we haven’t even discussed the expensing of options. (Options expensing are a large part of the reason tech stocks have gone nowhere). Options, in all their myriad forms, are weighing on equity prices.

Earnings Management: Between Sarbanes Oxeley and execs going to jail, there’s no doubt the quality of accounting is significantly higher than it was. But what of the overall SPX earnings management?  There has been a disproportionate impact of share buybacks as a form of earnings management; Trimtabs notes nearly half a trillion dollars worth of stock repurchases were made in 2005. Measuring operating earnings in dollar terms (not per-share net basis) shows year over year gains of less than 8% — not the 12-15% widely reported.

Today’s WSJ has an article detailing how companies are increasingly issuing debt to pay for share buybacks. As Merrill Lynch’s David Rosenberg describes it, there’s a good deal less to the corporate bottom line than meets eye.

Leadership:  What sectors are putting up the strongest overall numbers? Is it finance technology and consumer discretionary? Or, are materials, energy and utilities leading? The sectors providing the most disproportionate bang for the earnings buck are quite revealing as to what is going on in the economy.

These five elements will determine whether this earnings season is a pleasant surprise or a  disappointment.

Note that Wall Street tends to be poor at forecasting these changes at turning points; At a forward SPX P/E of 15-16, the market is certainly not terribly expensive — but its hardly cheap, either. I would call it fairly valued.

Keep in mind that forward earnings projections are merely opinions; If they turn out to be too optimistic — and we have already seen some hints that perhaps they are — then the market can suddenly become more expensive in a hurry.

That means the risks to the downside are increasing . . .

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  1. Dave commented on Jul 11

    The bulls have been counting on corporate earnings growth to bail them out. Frankly I don’t see it happening. Any company that has missed on revenues, EPS, or disappointing forward guidance has been sold off in a hurry. It’s going to take some near perfect earnings results to save this market, and those might already be priced it.

    I’m sure alot of bulls have been shocked by MMM’s announcement seeing that 3M has been one of the more solid companies in the Dow tracing back to 1987. A lot of bulls were also counting on Alcoa to beat the street estimates. That didn’t happen, and I’m sure the whisper number was higher. That’s probably why it sold off yesterday after earnings came out.

  2. Mr. Beach commented on Jul 11

    Barry: As always, thanks for the crib sheet.

    My experience in sales and marketing suggests that we’re going to continue to see fallout from the market drop in May. In particular, I remember having quite a bit of trouble attempting to close deals during prior periods of market volatility — customers would get nervous and begin to delay or review the merits of deals more thoroughly.

    So my wild ass guess: the market volatility of spring is going to contribute to volatility in Q2 earnings.

  3. royce commented on Jul 11

    The market does seem to be reasonably priced as everyone waits to see whether there’s a downturn in earnings. Exchanging debt to buy back shares? Oh, man. That doesn’t sound good.

  4. Barry Ritholtz commented on Jul 11

    Hey, is it just me, or did CNBC nearly lift this verbatim 3 minutes ago ?

  5. Mark commented on Jul 11

    Hah! Someone lifted your take and ran with it on Bull Market Central! Too rich!

  6. james commented on Jul 11

    The market IS EXPENSIVE – even many bears like Barry are missing this. So many investors are corrupted by reference dependence – comparing current valuations to those of the 1995+ years…which were bubble years. In addition, a simple P/E that does not account for profit margins is near worthless. Dr. John Hussman has written a lot about price to peak earnings with the long term median at 11-12 x’s TRAILING earnings. This nonsense of using forward operating earnings is….nonsense! The S&P 500 would have to trade to 800 to hit the median of 12x’s earnings. Tracking peak earnings is one way to prevent being seduced by unrealistic growth rates that Wall St trumpets based on trough to peak.

  7. Bynocerus commented on Jul 11

    What is it about 10:00? With apologies to George Harrison:

    Little darling, it’s been an uneventful morning
    Little darling, it feels like years since it’s been here
    It’s ten o’clock, here come the shorts
    and I say it’s all right

    Little darling, the frowns returning to bulls’ faces
    Little darling, it seems like years since we’ve gone up
    It’s ten o’clock, here come the shorts
    and I say it’s all right

    shorts, shorts, shorts, here they come…

  8. Bob A commented on Jul 11

    I heard someone’s writing a new book named “The dumbest President who ever lived”

  9. Mark commented on Jul 11


    Looked at HET. Are you thinking about playing it straight up, with options, hedging it, what? And why now (or in a couple weeks)?

  10. george harrison commented on Jul 11


    i’m back from the dead to tell you your a fool and a rather pathetic lyricist. good lord.

  11. Bynocerus commented on Jul 11

    I may be a fool, but at least I know the difference between saying you’re a fool and your [sic] a fool. Guess I’ll have to spend less time trading and more on rewriting Rock & Roll classics.

    Glad to know your contributions so far have been name changes and flames. Where’s that damn registration process when you need it?

  12. Michael C. commented on Jul 11

    The big positive that I was watching (expanding new highs) has been dwarfed by the negatives on this leg down.

    The VIX, VXN, P/C ratio all show complacency even as the Nasdaq is bleeding to new lows. I think alot has to do with the “hope” of the upcoming earnings causing alot of people to holdout.

    Not a great setup.

  13. Mark commented on Jul 11

    Water off a duck’s back Byno. Water off a duck’s back.

    Very disheartening to see flaming going on on this board, Barry. Time to get out your ruler and rap a knuckle or two.

  14. Alaskan Pete commented on Jul 11

    Hey Mark, I will play it straight up (i.e. long the shares) if and when I get a signal with a stop pretty close to the trendline on the weekly (I adjust stops for volatility in the specific issue rather than using a set %). I don’t think it triggers for another week or two, but it’s getting close and has moved from my end of week review list to daily review. They report on 7/27.

  15. Whamer commented on Jul 11

    The combination of the options and the share buybacks is becoming particularly toxic for tech. Take a look at CSCO — over the last 5 years the stock price is flat to down somewhat. However, there are about 1 billion fewer shares outstanding than there were in 2001.

    Therefore, CSCO market cap has dropped by roughly $20-25 billion in the last 5 years. However, the exercise price on employee options remains the same. So that means the absolute value of the stock price is very important to compensation, particularly to senior execs. Over the next 18 months or so, the options granted 10 years ago will hit the “exercise or lose it” date, and those options are still in the money — exercise prices are under $10. There are about $1 Billion worth of those options that need to be exercised over that time. That averages out to ~$150 million per quarter earnings hit — not enormous for CSCO, but not trivial either.

    I have to imagine that most of the large cap techs are in the same/similar boat, because the employee option grants have a lifetime of 10 years after they are granted.

    BTW, this could be driving some of the increased tax revenues that we’re seeing now. People are hitting time-based windows that force them to take their option income based on grants that they received in 1996/97.

  16. Ned commented on Jul 12

    and it’s My Sweet Lord not good lord.

  17. The Big Picture commented on Jul 22

    Options Trouble Punishing Tech

    Back on July 11th, we warned that Options were going to be a key trouble spot for stocks:Options Options Options: Between the option backdating scandals, and more recently, spring-loaded options, we haven’t even discussed the expensing of options. (Opt…

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