The hope with lowering expectations is that one can be pleasantly surprised.
Every quarter, Wall Street analysts and equity investors play the game of lowered expectations for company earnings and approaching the halfway mark of the current reporting season, once again share prices are being buoyed by upbeat results.
US equities, which spent a portion of the first quarter in negative territory, have rebounded, with the S&P 500 setting a new intraday high on Thursday, while the technology-heavy Nasdaq Composite eclipsed the record close that marked the internet bubble peak in 2000.
That suggests investors were prepared for the ramifications of a sharp rise in the US dollar influencing the financial performance of US companies over the first three months of the year.
“There was a lot of uncertainty about how bad the impact from foreign exchange would be,” says Eric Slover, an equities strategist at Barclays. “It looks like it was not only in analysts’ estimates, but the market had discounted it as well.”
The dollar’s rise in recent months, along with falling energy prices, led to the largest downgrade of earnings estimates since the financial crisis, setting up the first and second quarter for a “ profit recession”: when earnings on a year-over-year comparison decline for two consecutive quarters.
The surging dollar, on the prospect of tighter monetary policy from the Federal Reserve this year, cast a pall over sales and profits estimates for the largest American companies, just as signs of a rebound in European economic activity have appeared.
Indeed, dozens of multinationals based in the US have reported nine-figure cuts to sales, as companies translate revenues earned abroad back into the greenback. Among the hardest hit: Amazon, General Motors, IBM, Johnson & Johnson and Procter & Gamble, which have all reported $1bn-plus sales cuts because of the strength in the dollar.
US earnings nonetheless are beating lowered expectations. Some 73 per cent of companies have surpassed analysts’ estimates, according to FactSet, in line with the five-year average.
Conversely, revenues are running below expectations. Some 53 per cent of companies have missed estimates. The five-year average shows 58 per cent beating expectations.
“For the bottom line you have natural hedges, for example if a company sells into Europe but it produces in Europe, and derivatives hedges. That protects a lot of companies,” says Mr Slover.
Companies can also cut costs to compensate for lower revenue growth.
Dubravko Lakos-Bujas, an equity strategist with JPMorgan, says the negative revisions heading into the first quarter were likely “overdone . . . setting up for positive surprises” as companies report over the quarter.
“While we do not anticipate anywhere close to a full recovery of negative earnings revisions, we believe 2-4 per cent earnings surprises during this season are likely, due to a severe pre-announcement cycle and depressed Street expectations,” he says.
In contrast with US multinationals, a weaker euro has proven a boon to European corporates, which must translate dollar earnings in North America back into the euro. L’Oréal, the French cosmetics behemoth, put 8.9 percentage points of its 14.1 per cent sales gain down to currency swings — or more than €500m.
The benefits of a higher US currency for European companies is one factor drawing investors from US equities to European bourses, which even in dollar terms have outperformed the S&P 500 so far this year.
“What a lot of investors are asking themselves is whether it is time to look outside the US where some of the countries have seen depressed economic growth rates,” says Dan Kelley, a portfolio manager at Fidelity. “Based on the earnings reports, investors are asking whether we are starting to see inflecting growth outside the US.”
But better than expected US earnings of late have underpinned US stocks. That has come even though a blended rate of reported results and estimates shows a year-over-year decline of 2.8 per cent in earnings and 3.5 per cent for revenues in the first quarter, which would be the worst showing for both since the aftermath of the financial crisis in the third quarter of 2009, FactSet data show.
In the run-up to the latest profits season, US companies with large overseas operations underperformed those that are primarily domestic. Now the reverse is happening. Since the end of March, shares of companies with less than 50 per cent of sales in the US have risen 2.6 per cent versus 1.6 per cent for the broader S&P 500 and 1.2 per cent for companies that get most of their sales in the US.
By the end of Friday, about 40 per cent of companies in the S&P 500 will have reported, and earnings for key companies, such as Apple, are still to come. If the rest of the earnings season supports the initial reading, the ageing US equities market may yet again escape what could have been a catalyst for a long overdue correction. The market has not fallen more than 10 per cent in a few years.
“The market is way overdue statistically for a correction,” says Randy Frederick, a strategist at Charles Schwab, “but it won’t happen without a catalyst.”