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All eyes on earnings

Tom Stevenson

Tom Stevenson - Investment Director

It is sometimes said that in the short-term the stock market is a vote counter but in the long run it’s a weighing machine.

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This means that while market movements can be determined over short periods by changes in sentiment (counting the votes), over longer time-frames share prices are determined by corporate earnings growth (their weight).

This is why quality-focused investors tend to say that, within reason, they disregard the valuation of a company’s shares - they focus instead on the sustainability of its profit growth. In the long-run, they argue, this will be the primary determinant of how successful an investment turns out to be.

The focus on earnings means that the quarterly results round is always under the spotlight for investors. But there has rarely been as much attention showered on an earnings season as the one that kicks off this week. Around 60 of the 500 companies in the S&P 500 benchmark are due to report over the next few days.

The scrutiny is more intense this quarter because of the fear that earnings are going into reverse after many years of improvement. As with an economic recession, the definition of an earnings recession is two consecutive quarterly declines. Profits fell in the first quarter and they are expected to do so again in the three months to June.

S&P 500 companies are forecast to report a 2.8% fall in the second quarter. That follows a 0.3% dip in the first three months.

Move further down the size scale and the slowdown is expected to be even more pronounced. Mid-caps are expected to deliver profits 5% lower than a year earlier. Small-caps have a double-digit slide pencilled in.

The reason this matters is that the S&P 500 has this week hit another all-time high of just above 3,000. Investors are banking on earnings growth bouncing back quickly from the current slowdown on the back of lower interest rates, a resolution of recent trade tensions and perhaps some pre-election fiscal stimulus too.

That weight of expectation means there is plenty of scope for disappointment on all three fronts. And investors will therefore be watching closely the comments that accompany results releases as much as the numbers themselves.

One of the other key focuses for investors will be the outlook for company profit margins. These have been rising for a long time as wage growth has remained subdued, the cost of funding borrowings has been low and revenue growth has been high.

Analysts now expect a decline in non-financial company margins from 11.5% a year ago to 10.8%. That is not, in itself, a big fall, but it does put to an important reversal of a long-term trend away from labour and towards capital, and therefore shareholders.

When it comes to the sector mix, the industries most exposed to China look like being the hardest hit. Materials businesses - companies like DuPont, for example - are expected to see double digit declines in both sales and profits compared with last year.

Importantly, given its long-term outperformance, technology is also expected to experience heavy declines in earnings. Perhaps unsurprisingly, it is the defensive sectors like utilities and healthcare that are forecast to hold up best.

One other factor that investors are likely to focus on is the level of the dollar, which has been stronger than expected recently. That sounds like good news for American companies but is actually a headwind because it makes US exports less competitive and businesses’ overseas earnings less valuable on translation back into the US currency.

So, there is plenty to watch out for and investors need to weigh up the pros and cons of investing in the US at what looks like a potential turning point for corporate profits.

For more on the prospects for the US stock market and all of the other main markets and asset classes, take a look at the latest Investment Outlook from Fidelity Personal Investing, which was launched last week with a live, interactive question and answer session.

You can watch this webcast in catch-up and download the full report here.

Five year performance

(%)
As at 30 June
2014-2015 2015-2016 2016-2017 2017-2018 2018-2019
S&P 500 7.3 3.5 17.9 14.5 11.2

Past performance is not a reliable indicator of future returns

Source: Refinitiv from 30.6.14 to 30.6.19. Total returns in local currency.

Important information

The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.