Checking in on Earnings

Stocks Post Best Week of 2014

Stocks posted their strongest week of performance on the year, rebounding from a choppy start to 2014. Janet Yellen’s testimony before the House Financial Services Committee was enough to catapult risk assets, as her confirmation of the status quo at the Fed was welcomed by financial markets. For the week, the S&P 500 rose 2.4% while the Dow Jones Industrial Average added 2.5%.

Although Yellen’s second day of testimony in Washington was delayed due to inclement weather, financial markets clearly heard enough in the first day to lift themselves out of the early 2014 funk. Speaking publicly for the first time, Yellen noted that she would not be deviating from prior Fed policy: “I expect a great deal of continuity in the FOMC’s approach to monetary policy. I served on the Committee as we formulated our current policy strategy, and I strongly support that strategy.” Yellen served as Vice Chairman to Ben Bernanke prior to being confirmed as Chairman in January.

Although Yellen’s philosophy was widely considered as such, last week’s comments affirmed her position and the outlook for Fed policy moving forward. Stock markets had suffered their deepest drawdown since late 2012 as some level of uncertainty lingered following her confirmation.

Despite the optimism surrounding the Fed, economic data was mostly disappointing last week. Headline reports concerning US consumption and manufacturing came in very soft, lending further credence to the notion that extraordinarily cold January weather is having a detrimental economic impact.

Retail sales contracted by 0.4% in January, led down by the automotive sector which declined 2.1%. The core level, which strips out autos and gasoline, held up somewhat better, but still finished flat for the month. Adding to the concern were negative revisions to December’s initial estimates. At the headline level, an initial 0.2% gain was revised down to a 0.1% loss. Worse still, the core level was compressed from an original 0.7% expansion to just 0.3%.

There is a broader level of concern following Thursday’s report that Q4’s 3.2% GDP figure could be revised down. More than 2.0% of that number was attributable to personal consumption expenditures in the BEA’s advance estimate.

On Friday, things did not get much better when industrial production was reported far below expectations. January’s 0.3% contraction was on the wrong side of an estimated 0.3% increase. The story was even uglier for the much-watched manufacturing component of the report, which fell 0.8% month-over-month. Poor weather actually helped the headline figure, as the utilities component spiked 4.1%.

Checking In On Earnings

Earnings season is nearing its finale, and the latest results show plenty of reason to be bullish, but the longer-term trend remains an outstanding question for markets.

Data from FactSet shows 71% of companies that reported in the S&P 500 were ahead of earnings. In addition, every sector shows at least 50% of companies outperforming earnings estimates.

Source: FactSet

As is typical, analysts have incrementally revised earnings estimates lower since the end of 2013, reducing the bar for companies to beat. Across the board, FactSet reports that bottom-up earnings per share estimates were down 3.0% since year-end.

Source: FactSet

Despite the aggregate news being positive, there are plenty of companies disappointing, and it is leading to opportunities for active managers to add value. Research from Bespoke Investment Group shows companies that fail to beat EPS estimates lost 2.5% the following day during this reporting season. Companies that beat are gaining more than 2.5% the next day.

Source: Bespoke Investment Group

Over a longer horizon, there is reason for caution. As a percent of GDP, pre-tax corporate profits are near multi-decade highs. McClellan Financial reports that earnings as a percent of GDP have only been higher in one instance during the past 46 years – 2006. A simple mean reversion approach suggests profits will need to give back some ground in the quarters ahead.

Corporate profits as percentage of GDP

Source: Pragmatic Capitalism, McClellan Financial

With the vast majority of earnings season behind us, the numbers have been impressive. A few companies are left to report, including the likes of Coca-Cola, Wal-Mart, Nordstrom, HP, and Tesla. Barring any major shift, this quarter will go down as a good one for profitability, but the clock may be ticking on the sustainability of earnings.

The Week Ahead

There is a heavy amount of news flow this week, spanning central bank activity to economic data.

Front and center this week will be minutes from January’s FOMC meeting. The transcripts will be scrubbed for any additional insight into the Fed’s decision-making around the tapering process.

Economic data includes housing starts, existing home sales, CPI, and the New York and Philadelphia regional manufacturing surveys.

In Europe, two important gatherings of European officials take place with the Eurogroup and ECOFIN. Minutes are also due from the most recent Bank of England meeting.

Central banks meeting this week include Turkey, Hungary, and Chile.

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