Q2 Earnings Shaping Up Well

Q2 Earnings Will Likely Be Good

With central banks putting out guidance to shrink their balance sheets or taper buying and with U.S. fiscal stimulus delayed by at least a few months, earnings are more important than ever to keep the market up. As long as earnings growth is solid, the market should be steady. Many passive investors don’t pay attention to the fundamentals; they just watch the prices. If earnings start to disappoint, money managers will pull out, which could start a cascade of selling from passive investors because they will be afraid of price declines. This cascade effect didn’t happen during the 2015-2016 earnings recession because buybacks and easy Fed policy kept the bull market going. There was also less passive money involved than there is now. There was a recession scare in early 2016 and two corrections, so it wasn’t a perfect scenario. I am forecasting buybacks to resume their march higher in the second half of 2017, but that can only occur if earnings beat expectations.

The first quarter was great because estimates were beat and they were never lowered that far to begin with. Although earnings comps are tougher in Q2, so year over year growth will be lower sequentially, the pre-earnings period is looking great again. As you can see from the chart below, the Q2 bottoms up earnings estimates have perked up in the past week which is very good news because usually they fall sharply right before reporting starts. With earnings season starting in the next couple weeks, it looks like the estimates that are in place now will be close to what is expected when reporting commences. Analysts have cut forecasts 2% this pre-earnings period which is half the size of the average cut. The 6.6% expected operating earnings growth in Q2 is an implied increase of 9.5% because earnings beat estimates by 2.9% on average (FactSet numbers).

The energy sector is the most at risk to miss estimates because oil was lower than expected in Q2. You can see the disconnect between what analysts are expecting and reality from the chart below. The bottom-up target prices for energy firms implies 23.1% upside. You’d think that would be an acceptable estimate given the 396% earnings growth expected in Q2, but that reflects the fact that energy stocks have fallen because oil prices have fallen. Analysts haven’t caught up with the stocks by cutting forecasts for Q3 earnings. One reason why analysts haven’t caught up is because they can’t chase oil around daily by constantly changing future estimates. It needs to stay low for an extended period for it to start effecting earnings. Energy firms will likely report decent results in Q2 and lower guidance for the rest of the year. Since oil stocks have already fallen, pricing in this downward revision, I don’t see it affecting them. However, it could hurt the banks who have given out energy loans. It also will negatively affect the businesses and consumers in the areas where shale oil employs the most people such as North Dakota and Texas.

With earnings in center stage, it will be tough for the bulls to justify the decline in aggregate earnings expectations in the second half due to the declines in energy estimates. We may already be seeing the answer to question of how this decline will affect stocks by looking at the bond market. The options adjusted spreads in energy are widening, while they remain tight in the junk bond market as a whole. Although earnings are being focused on more now than in 2015, the one good thing on the bulls’ side is that earnings excluding energy are stronger than they were in 2014. In Q3 2014, the energy sector contributed $12.56 to bottom-up S&P 500 earnings, while in Q1 2017 the sector only earned $3.88 to bottom-up earnings. Even in Q3 2017, energy is only expected to contribute $4.48 to earnings. The estimate cuts which will come from energy in the 2nd half won’t cause the aggregate to fall as much it did in the earnings recession of 2014-2015, but it’s still significant for earnings growth because the aggregate was driven by energy in Q1.

Total 2017 operating earnings, according to FactSet, are expected to grow 9.8%. My bearish outlook for earnings which expected them to grow (5%-7%) could still be hit, but I expect analysts’ estimate to increase temporarily after earnings beat expectations in Q2. To be clear, that’s not a prediction; it’s an expectation which almost always comes true. Earnings almost always beat estimates. The determining factor on how good a quarter is whether earnings beat by more or less than 2.9%.

Ethereum Crash

As I mentioned in a previous article, I am very bearish on Ethereum and Bitcoin in the near-term. Ethereum is the second largest cryptocurrency. It is a platform for smart contracts. The first application of Ethereum is ICOs which are initial coin offerings. An ICO is a method of raising money for startups without 3rd parties. Companies issue their own coins to raise money. The problem with this situation is that many firms which have no business models are taking advantage of the speculative craze surrounding the advancement by doing an ICO to raise money for their terrible businesses at crazy valuations.

It’s bad for Ethereum to have such a craze behind it. When the speculation fizzles in these ICOs, Ethereum’s price will likely fall dramatically. It already has fallen hard in the past few days. The last time I checked, it was at $220. That’s almost a 50% decline from the $400 all-time high. I expect all the alt-coins to drop in value as the speculation wanes. The percentage share Bitcoin has in the overall cryptocurrency space fell to the high 30s because of the increase in Ripple, Ethereum, and others. My prediction is for Bitcoin to regain an over 50% share when the hype goes away.

Although Ethereum has existed since 2015 and many other alt-coins have been around longer, this period in Q2 2017 is the first time investors have gotten rabidly involved in the alt-coin space. Prior to this year, alt-coins were mostly considered duds. Some of the speculation occurred because private businesses started investing in blockchain technology for private ledgers. When blockchain became the buzzword, it was inevitable that alt-coins would gain prominence because they use blockchain and aren’t Bitcoin. The question is what value they provide that Bitcoin doesn’t. Personally, I don’t see the value they add which is why I think it’s time to shy away from them. I would buy Bitcoin on the dip if it falls below $2,000, but avoid the others.

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