You’ll often hear a pundit make the comment that “earnings should be strong” for this sector or that market. It’s meaningless absent the context of expectations. If earnings are strong, but the market expects them to be strong, then this pronouncement has not only zero value for the listener, but probably negative value. This sort of superficiality is good for cocktail party chatter or television prattle, but it doesn’t actually make anyone a dime.
Energy stocks in the second quarter offer a great illustration of this. Energy are the worst performing sector in the S&P 500 this year and especially during the second quarter, during which they seemingly declined every week.
Here’s a performance chart by sector beginning at the end of Q1 through Friday, Energy is in black:
Now let’s take a look at the earnings estimates for the second quarter – these earnings reports are just starting to trickle in now…
If you were overweighting a portfolio based on which stocks were poised to delivery “strong earnings”, you would undoubtedly be overweight the worst performing stocks in the whole market. Have a look at this past quarter’s expected / reported earnings growth – that giant bar towering over the rest of the sectors on the left is Energy:
The blended (combines actual results for companies that have reported and estimated results for companies that have yet to report) year-over-year earnings growth rate for Q2 2017 is 6.5% today. On June 30, the estimated earnings growth rate was 6.6%. Nine sectors are reporting or are predicted to report year-over-year earnings growth, led by the Energy, Information Technology, and Financials sectors.
It’s important to be able to differentiate the outlook for a sector or market vs the expectations investors already entertain about it. This is obviously the hard part, which is why there is money to be made for a very select group of folks who happen to guess right about this from time to time.
If I had told you, at the start of Q2, that the S&P 500’s Energy names were going to put up earnings growth of almost 400% for the coming quarter, light years ahead of what every other sector was about to report, you may have inferred that this would lead to profits in holding the stocks.
It doesn’t work that way.
The market had already priced in the EPS recovery for the Energy sector far in advance of the second quarter and was already selling these stocks down on concerns of the recovery being largely reflected.
Remember this the next time you hear about the outlook for something being “strong” or “weak” or whatever. On the tip of your tongue should always be the rejoinder “Yes, but ‘strong’ relative to what?”