What I’ll be watching for during earnings season

This week corporations began reporting their quarterly earnings (half year for most of them.)  Many analysts expect large corporate revenues to be flat and for profits to be lackluster.  This differs from previous years where cost cutting has yielded exceptional profits despite mediocre revenues and cost cutting may have run its course.  While analyst mood is cautious, we may be witnessing groupthink.  From my perspective, analysts tend to have an early conservative bias so that any upside earnings reports make them look like heroes to happy clients.  Negative reporting surprises, such as lower earnings than expected, make everyone unhappy.  So why risk being too optimistic?

Bad news bears?

No doubt about it, there are plenty of reasons to be negative.  Some of the most recent headlines underscore the fragility of the US economy.  Some highlights:

• Economists have lowered expectations for the rate of GDP growth
• Large banks are worried that increased capital requirements proposed by the FDIC will subdue future profitability
• Thursday’s unemployment claims were higher than expected, a troubling sign for consumer spending
• Everyone is worried (including the Fed) that an increase in interest rates caused by a slowdown in bond buying (aka the “taper tantrum”) along with investors selling their bonds will cause the recent run up in interest rates to stick
• Sequestration continues and another debt ceiling drama looms

Reasons for upside surprises and what to watch

While the rest of the world seems to be stuck in the summer doldrums (China’s exports are down, Greece and Eurozone struggling), the US is chugging along albeit at a slow pace. Amidst the recent volatility and turmoil, there are some bright spots:

• Mid-cap and small-caps could continue to benefit from US investors sticking close to home.  Unlike S&P 500 companies, with roughly 40% of profits coming from outside the US, domestically oriented businesses should fare better.
• Similarly, those large companies or sectors with a bias toward US industries and consumers should fare better overall than those oriented toward emerging markets or European economies.
• Valuation:  And while it makes sense that domestic companies fare better, I am an advocate of considering valuation as an investment criterion.  A good long-term investment strategy to choose is investing in out of favor stocks with low price to earnings ratios that may rebound with global growth.  As shown in the chart below, Energy, Technology and Materials stocks continue to lag while those sectors that have outperformed this year may be due for a breather.   Along this same strategy, battered international companies with good long-term prospects that look cheap may be good buys now.

In the coming weeks, we will consider earnings and sector performance more closely in the weeks to come for clues regarding ongoing investment themes.  Just as the axiom says, “Buy low and sell high.

The leading sectors of the market in the second quarter are consistent with the first quarter