The light at the end of the earnings tunnel


By David Kelly, Chief Global Strategist, JP Morgan Asset Management

This week will see US earnings season start in earnest with 35 S&P 500 companies reporting.  Expectations are modest with analysts now forecasting an operating earnings number of $28.45, down 3.9% from a year ago.  This follows year-over-year declines of 5.3%, 5.5% and 10.9% over the past three quarters according to Standard and Poor’s.

For investors it is important to recognise two things: The dismal performance of profits in 2015 can be entirely explained by weak oil prices and a strong dollar. These drags should fade in the fourth quarter and disappear altogether in 2016, setting up a sharp rebound in earnings in 2016.

On the first issue, from 2013 Q4 to 2014 Q3, the energy sector of the S&P 500 contributed an average of $3.32 or 11.9% to average quarterly earnings of $28.63.  In 2014 Q4, this contribution fell to $2.00 and in the first two quarters of 2015, it fell to – $0.14 and -$0.15 respectively.

This, of course, was due to a collapse in oil prices from over $100 a barrel in the spring of 2014 to below $50 today.  However, $50 is very likely below an equilibrium price so that, even with substantial global inventories, oil prices are likely to drift sideways to up in the months ahead.  By the fourth quarter of this year, the energy sector comps will look a lot easier.  By the first quarter of 2016, the energy sector will likely be contributing to year-over-year earnings growth.

Similarly, the US dollar soared in late 2014 and was up 17.9% year over year (using the Fed’s major currency index) in the third quarter of this year.  For those S&P500 companies that provide sufficient detail for the calculations, more than 40% of revenues come from abroad.  A 17.9% increase in the value of the dollar implies a 15.2% decline in the value of foreign currency, suggesting a 6% year-over-year decline in revenues from the dollar effect alone, likely with a similar impact on earnings.

This has also been a problem throughout 2015.  However, if the dollar stays at current levels, it will be up just 9.6% year-over-year in the fourth quarter and 1.2% in the first quarter of next year.  For those who suggest that the dollar must rise further in the wake of Fed tightening, it is worth noting that the last three times the Fed began to tighten, the dollar rose in anticipation of the first tightening move and then fell once the tightening had commenced.

In addition, last week’s ugly trade numbers confirm that, from a fundamental perspective, the US dollar is too high as we are running a substantial trade deficit while Europe, China and Japan all run trade surpluses.

The bottom line on earnings is that while the season just commencing could be difficult, the fourth quarter numbers should be better and, by early 2016, US corporations should again be posting very strong year-over-year results.