While the well-prepared Hillary Clinton is unlikely to fail her hardcore fans at the Democratic debate this evening, earnings season may fail unprepared, suddenly excited investors.
The market has generally traded with a bullish bias in the past week or so, propelled by a dovish set of Federal Reserve minutes. What's odd is that every Fed member since the last FOMC meeting has voiced support for a rate hike before 2015 concludes.
Also interesting is that leading this short-term rally in equities are the beaten-up materials and energy sectors. Did anyone see that Alcoa (AA) earnings release? How about its breakup decision, which smacks of a management team trying to save their own gigs because China is flooded with materials produced by Alcoa.
Despite the pockets of good news, there has certainly been a bevy of suspect news that investors have chosen to disregard. That decision will likely come home to roost during the next three weeks of earnings season if positions are not dutifully pared down -- like today.
It would seem that the usually behind-the-curve Wall Street analysts already know earnings season disappointment is lurking. As investors have climbed back into the market, both sales and earnings estimates have trended lower for S&P 500 companies (see charts below). What that means is that investors are willfully paying heartier valuations to own companies that could flat out underwhelm on earnings releases and earnings call commentary.
One must stop with the mindset that companies always tend to beat lowered estimates -- it's not happening as consistently as it did from 2010 to 2014. And being complacent in this regard is one way losses add up quickly in a portfolio.
Here are three areas of failure that are likely to surface from companies in coming weeks.
Sales: For multinationals, they are likely to learn a valuable lesson this earnings season: total sales actually matter to valuing their stocks. For years I have ingested reports from global companies highlighting "organic sales," a metric used to paint a more favorable backdrop for the business amidst severe currency volatility. Hey, most investors know squat about currency, so why shouldn't CFOs and marketing departments do their very best to get them to look beyond the pressured total sales figure. I believe the days of investors disregarding total sales is nearing an end.
The dollar's strength is crippling multinationals, and execs have to be held accountable for managing the headwinds through significant price increases abroad (which hurts volume), exiting certain overseas operations (I think you will see this at some point at Wal-Mart (WMT)), or slashing costs here at home. Wall Street may be badly underestimating the impact of currency, which calls into question why investors are willing to pay what they currently are to own many S&P 500 companies (or an S&P index ETF).
I would be most concerned with multinationals that are losing market share, or pricing products more competitively to maintain share, in this environment of harmful currency effects. Names such as Procter & Gamble (PG) and Kellogg (K) really bother me here for that very reason.
Earnings: As a result of currency headwinds, don't expect earnings to be any great shakes. There is only so much that share repurchases will do to pad the bottom line.
On the topic of share repurchases, be mindful of those companies that used the summer weakness in their stocks to buy back their stock. I think it could be a positive indicator, provided management teams aren't being given bonuses based on earnings performance (check the proxy filings).
By and large, you want to gravitate toward companies that are structurally lowering costs to counterbalance currency volatility and a slow growth environment that lends little pricing power. I like what General Mills (GIS) continues to do to remove costs and expenses. The company had solid gross margin improvement in most recent quarter.
Earnings calls: This may sound ridiculous, but companies have largely run out of exciting things to promote right now, or the types of things that would make an investor overlook a bad quarter. I don't think many companies are prepared to share much in the way of details for 2016 yet, and will use earnings calls to outline how they will improve results in the fourth quarter. For those companies that get on calls and discuss 2016 and 2017, and forget the fourth quarter exist ... run.
Speaking of failure, that may be the theme of Yum! Brands' (YUM) mid-December analyst day. I could see the bruised stock rallying a bit into the event on hopes of the company spinning off its China assets. However, I sense Yum! will be inclined to give a new leader of its China division some time to stabilize the ship in 2016, instead of selling valuable assets basically at the bottom of the segment's performance. In turn, the market may punish the stock at the December event. Buyer beware.