The Earnings Derby Week Two: Still Better Than Expected

In our June 29, blog we said that earnings for the second quarter would be better than expected. Our reason for taking that position is that three of the four portfolio managers at our firm have managed large businesses. In their roles as presidents or general managers of Health-care, Consumer, or Industrial companies they have seen first hand how powerful new management tools, such as Enterprise Resource Management (ERM), were giving them clearer pictures of revenue and expense trends. This increase in clarity enabled them to better calibrate capital and resources, which lead to better control over profits. Second quarter earnings are now in full swing, and as we had surmised, cost controls are winning the day and producing earnings surprise after earnings surprise. Here's the scorecard so far. With 38 of the S&P 500 companies reporting:

1. The average surprise or beat rate is 16%, much higher than the normal 3%-5%.
2. Thus far, there have been 30 companies that have beaten their Wall Street estimates versus 8 that have missed.
3. This 80% beat rate compares favorably to the 62% beat rate from last quarter.

The most important earnings surprises have come in the Consumer Discretionary sector, where 7 companies have reported positive surprises versus 0 negative surprises. Importantly, in the Finance sector, there have been 7 positive surprises compared with 4 negative surprises. The Health-care sector has registered 4 earnings beats and no earnings misses.

Only about 10% of the companies have reported in this earnings season, so early success does not assure the whole season will continue at this rate. However, we do believe there is a good argument that can be made that earnings for the whole season will now come in much better than expected, as our portfolio managers had predicted.

There is no question that these better-than-expected earnings have driven stock prices higher this week. We believe the earnings surprises will continue, although we think it will get progressively tougher to impress the market. This could lead to a flattening of the markets for a few weeks, as investors digest the new data.

Another key element in this quarter's earnings is how they stack up with last years earnings. The analysts were predicting that earnings this quarter would be approximately 30% lower than a year ago. For stock markets to continue their recent upward climb, we believe the total earnings for the quarter need to finish down closer to 20%.

We give you another report the end of next week.