Earnings Recession Averted

Earnings Recession Averted

Stock markets pundits have been working overtime in 2015. There is so much to speculate about: falling oil prices, Greek debt, a possible technology bubble and most of all, when the Federal Reserve will finally hike interest rates.

Recent attention has been on corporate earnings season. Companies began reporting their first quarter results in early April. The torrent is almost over, with 488 of the S&P 500 companies having reported as of last Friday.

My colleague David Levy wrote a great article back in 2013 explaining why earnings news usually doesn’t matter. Wall Street still plays the same games he described back then. I saw one new twist this quarter, though, and it’s worth noticing.

Going into this earnings season, analysts were the most pessimistic they have been in a long time. According to FactSet Research, as of March 31 the blended earnings growth rate forecast for the S&P 500 was -4.7%. That means they thought companies would, on average, post 4.7% lower profits in the first quarter of 2015 than they did in the same period a year earlier.

Now, 2014 was a good year so being somewhat less profitable this year would not be the end of the world for most companies. A business can make less than last year but remain solidly profitable. Nevertheless, investors want to see bottom-line growth, so companies are always under the gun to deliver it.

Why the downbeat forecasts? Lower oil prices were the reason cited by many analysts. The drop from $100 crude oil to around $50 was supposed to wreak havoc on energy company profit & loss statements. Pundits expected the damage to spread through related industries, too, and the stock market in general as companies slashed capital expenditures.

Reality turned out to be much different. Through May 22, earnings growth in large cap stocks rose 0.3% instead of falling 4.7%. Wall Street’s finest were overly pessimistic and underestimated how much energy companies could reduce costs.

Now, 0.3% growth is certainly not stellar. If this turns out to be the quarter’s final growth rate, it will be the lowest since the third quarter of 2012, when profits declined -1.0%. It still indicates this stock market is remarkably resilient against some unprecedented surprise events.

The largest energy companies performed better because they are more diversified and less leveraged than smaller explorers and producers. Refining, for example, was still a profitable niche within the wider energy complex. So was transportation and storage. As noted above, energy companies also slashed costs faster than analysts expected. They have learned how to scale capacity up and down quickly based on market conditions.

The greatest damage occurred in the energy service firms operating in high-cost U.S. and Canadian shale fields. Low prices rendered many projects unprofitable but management couldn’t turn off the machines fast enough. Companies that hedged their oil price exposure mitigated some of the losses.

The bigger issue, however, is that lower oil prices helped almost as many companies as they harmed. Airlines were one clear beneficiary. Delta (DAL) said it expects a net benefit of $2.2 billion as it pays less for fuel in 2015. Other transportation and shipping companies reported similar benefits.

Profits improved in the Health Care sector, too, particularly for the biotechnology niche. Large cap biotech stocks posted quarterly earnings 59% above the same period last year. Gilead Sciences (GILD) earnings almost doubled as it launched an expensive (but effective) new Hepatitis C drug.

This chart shows earnings growth by sector. You can see very clearly how much energy losses offset earnings growth in other sectors.

[Chart source: FactSet Research]

Consumer spending remains depressed as people apply their lower fuel bills to paying down debt instead of shopping sprees. Steady employment growth and higher wages are beginning to help, though, so we may see a consumer revival in the coming months.

Flat earnings growth is not great news, but it also doesn’t change the bigger picture. The “Plow Horse” economic recovery is still plodding forward. It has to stop and rest every so often, but it hasn’t gone backwards.

If 2015 ends like last year, we will see earnings growth concentrated in the second half. It may not terribly impressive, but it will continue nudging the economic recovery onward.

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