After the week we have endured in this market, I can't think of any more fitting lyrics than these, from the 1990s grunge band Bush: "Little things can kill, coming down the mountain."
The market has fretted over the big things -- Spain's fiscal problems, a rating downgrade in France before the election -- but really, as I take stock today, it's the little things on the earnings front that have killed. As time progressed over the past few days, the news built on itself until a crescendo was reached Thursday -- the Spain debt auction, macro madness on U.S. soil and, oh yes, those pesky press releases known as earnings reports. True, on the surface, earnings are appearing great. One has to get their hands dirty and venture into the murky waters of conference calls in order understand why good news is being sold.
What to Look For During Earnings Calls
Which segments of business are driving the earnings upside? For example, automotive and industrial were two general standout segments in the first quarter. However, commentary has been skewed toward a moderation in auto production and minor acknowledgement that second half-revenue trends in China and other emerging markets will be slower than they were the first half.
If earnings have missed consensus, is it due to timing or structural reasons? I would argue, for example, that Stanley Black & Decker's (SWK) earnings disappointment was timing-related. There was a disconnect existing between very robust point of sale trends at home centers, with sales gains of more than 20%, and mass merchants, which less frequently place actual new orders in order to replenish their inventories.
The granular language placed ahead of the word "Europe": I am hearing a fair number of companies use "slowing" or "slower" as opposed to "stabilized" when discussing demand in peripheral European Union countries. The fact that demand has not yet stabilizing at low levels -- essentially making a new step down -- creates risk to future earnings and cash flows from companies operating in Europe. This is straightforward dot-connecting.
Little Things Killing the Market
Compounding macro uncertainty: It's no longer acceptable to have macro data continue being at "high levels" or "stabilizing at low levels," as has been thrown our direction in the Philly Fed and existing home sales reports. (This trend began weeks earlier.) The collection of reports from mid-March on have added layers of questions that have yet to be factored into valuations, as they certainly were not in the first quarter. The market is currently in a tizzy on the question as to when, and to what degree, they will metastasize into forward earnings.
No belief in the sustainability of first-quarter top and bottom lines: Management teams are not helping their stock prices by only raising full-year earnings guidance to adjust for first-quarter upside, or reiterating the guidance. This implies worsening second-half fundamentals, and both of these bring into question the sustainability of three months of 2012 performance. Let's turn, once again, to Stanley Black & Decker. As I noted, its point-of-sale trends were up strongly, but management was unwilling to lift full-year earnings guidance, as new orders are still in a holding pattern. John Lundgren, one of the best-paid CEOs that you've never heard of, hinted that the range was appropriately conservative. Still, the market doesn't want to hear corporate gobbly-gook. It wants confidence.
Crazy tough love from Mr. Market: Tempur-Pedic (TPX) delivered double-digit percentage sales increases in all product categories in the U.S. and internationally, yet its stock was slaughtered. Lifetime Fitness (LTM) demonstrated that consumers are willing and able to pay more to break a sweat and grab a post-workout protein shake, yet its stock had a 50-pound dumbbell thrown at it. A $0.05 EPS beat for Snap-On (SNA) was hardly rewarded. The takeaway is that the market is dealing out some tough love, characterizing an environment in which merely solid is not solid enough. This, in turn, ignites fear in the minds of investors trying to identify individual winners from specific sectors: Instead of getting constructive, they opt to sell prior to earnings or avoid saddling up to the bar altogether.
Moreover, usually if one company beats, other stocks in the space will rise in sympathy, but that is not happening. Going a step further, corporate earnings shortfalls tend to imply that another company in the same sector could be a market-share gainer, and that the stock is worthy of purchase in front of a potential financial surprise. Unfortunately, the normal linkages I so often find are failing to rear their heads.
Thus far, as far as my specific stock calls are concerned, I have refrained from being a superhero on stocks ahead of earnings. Stanley Black & Decker was a reiteration of a buy call that I inked here in December, and Snap-On is a call I can live with, as the market's response -- shares up 3% or so -- was not enough for me to put a hole through the wall. Other than that, I am OK with not firing bullets in a steel-lined room. The market is telling us there's a high probability that quality names will be available at cheaper valuations, and that is a message I am inclined to respect in the near term.
Friday Fun Note
• Stanley Black & Decker's organic sales declined 3% in Canada despite a hot housing market, and they fell 5% in Australia. For that latter item, competitive factors were cited -- but is there a China link here, too?
• 10-year U.S. Treasury notes have yielded below 2% for five straight trading days as companies have announced much-better-than-expected earnings.
• First indications are in that inventories at major retailers are quite lean. We're seeing lean inventories and strong sales to start the year, per the retail reports, so profit margins have a good chance to surprise. Also consider the cautious guidance moving off fourth-quarter earnings calls. Lean inventories will require replenishment, and may partially explain why Skechers (SKX), Crocs (CROX), Perry Ellis (PERY) and Carters (CRI) have had stock prices defying the market's tough love in recent sessions.
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