First Half of Earnings Season Leaves Investors Craving More

Earnings season has entered halftime and the first-half results may have some investors needing a pep talk.

The first-half picture is a familiar one: cost-cutting fueled earnings beats that help mask an eyebrow-raising number of revenue misses. Barely half of the S&P 500 companies that have reported results have beaten revenue expectations, which is well below the four-year average.

The top-line struggles this earnings season highlight the sluggish economic setting that makes revenue growth challenging to sustain.

“It’s been a difficult operating environment. It’s clear to us that companies are stretching just to get to the consensus estimate,” said Jim Russell, senior equity strategist at U.S. Bancorp’s (NYSE:USB) U.S. Bank Wealth Management.

Despite legitimate questions about the health of corporate earnings, U.S. stocks continue to trek into unchartered. The S&P 500 rallied 0.88% last week, its third-straight weekly gain, and landed at its 31st record high this year alone.

That’s because investors have been more focused on the resolution of the fiscal standoff in Washington and expectations that the Federal Reserve will keep its very easy monetary policy stance in place into early next year.

“We do think the backdrop for stocks is very encouraging. The missing link is probably strong earnings growth,” said Russell.

Quality Questions 

According to FactSet (NYSE:FDS), about three-quarters of the S&P 500 companies that reported third-quarter results through Friday logged actual EPS that was above consensus calls from analysts. That compares well with the average of 70% over the past four quarters and 73% over the past four years.

However, the quality of the bottom-line results has been uninspiring.

S&P 500 companies have reported third-quarter profits that are an average of just 0.8% above expectations, which is well below the four-year average of 3.7%. In fact, FactSet said this would mark the lowest surprise percentage since the scary fourth quarter of 2008, when profits disappointed by a whopping 62% amid the near collapse of the financial system.

“You definitely have to question the quality of the earnings” given how dependent companies have become on cost-cutting moves, said Gregory Harrison, corporate earnings research analyst at Thomson Reuters (NYSE:TRI). “They are always going to do their best to beat the earnings estimates, but if revenue is not there it’s tougher to do that.”

Banks Skew Earnings Picture

In addition to cost cutting, companies have padded their bottom lines with a slew of other one-time measures, including share buybacks, debt refinancing and lower loan-loss provisions.

According to The Wall Street Journal, loan-loss reserve releases made up 18% of the third-quarter pretax income excluding special items from JPMorgan Chase (NYSE:JPM), Wells Fargo (NYSE:WFC), Bank of America (NYSE:BAC) and Citigroup (NYSE:C). That represents the highest level for that measure in a year.

“That’s a sign that credit quality is improving… but you can’t do that forever,” said Russell.

The overall earnings numbers have been further skewed by a number of unusually large negative EPS surprises in the financial sector from SunTrust Banks (NYSE:STI), BB&T (NYSE:BBT) and especially JPMorgan.

Slammed by $9.2 billion in legal expenses, JPMorgan disclosed a loss of 17 cents a share, which is well below the Street’s estimate for a profit of $1.19 a share.

Excluding JPMorgan’s big miss, Harrison said S&P 500 earnings would be up 6% during the third quarter, which is better than anticipated.

Top-Line Troubles

From a revenue perspective, 52% of S&P 500 companies that have reported results have beaten sales expectations, FactSet said. That’s slightly above the average from the past four quarters of 48%, but well below the four-year average of 59%.

On average, sales have come in 0.2% below expectations, which isn’t even close to the four-year average of a revenue beat of 0.7%.

“Very weak revenue is attached to very weak global and domestic GDP growth,” said Russell.

Overall, Russell said he would give the first half of earnings season a “barely passing grade” of a C+. “We will need stronger earnings growth to maintain current market levels and move the ball forward,” he said.

Diverging Picture

Of course, there have been some bright spots this earnings season.

Led by names like Google (NASDAQ:GOOG) and Microsoft (NASDAQ:MSFT), the tech sector is expected to post third-quarter earnings growth of 5.81%, which is above estimates for 2.6% as of October 1, according to S&P Capital IQ. About two-thirds of IT companies have beaten revenue expectations, FactSet said.

Another strong point has been the consumer-discretionary sector, which sports the highest earnings growth rate at 8.2%. FactSet said ten of the sector’s 12 industries are reporting or are expected to report earnings growth, led by double-digit growth from Internet and catalog retail and household durables.

“There is a little bit of have's and have-not's tiering in the third quarter. Some of the more strongly positioned companies are doing well at the expense of the other ones,” said Russell.

He pointed to the big earnings beat from Google and weakness from IBM (NYSE:IBM) as well as Boeing’s (NYSE:BA) strong third-quarter results that contrasted with sluggishness for Caterpillar (NYSE:CAT).

Likewise, small and mid-size companies, which tend to have less international exposure, have enjoyed significantly stronger results than large-cap ones. Perhaps that explains why the small-cap heavy Russell 2000 is in the midst of its longest weekly winning streak in more than 10 years.

What About 4Q?

There is reason to be cautious about the guidance companies are giving going forward.

Out of the 57 S&P 500 companies that issued guidance for the fourth quarter, 49 have released negative guidance, FactSet said. That means 86% of companies have given negative EPS guidance, which is uncomfortably above the five-year average of 63%.

But Russell said investors should realize that comparisons with the fourth quarter of 2012 should ease the pain next earnings season.

“I think the earnings momentum will pick up in the fourth quarter, but not because we’re going gangbusters from an operating standpoint. Only because of easy comparisons,” he said.