What is “Earnings Season?”
In finance and economics everything seems to revolve around a quarter. A recurring three-month cycle that companies use to summarize operational results. Earnings season is the time frame, after quarter end, that public companies report financial results to the public — a significant period for investors to glean insight about specific companies and implications for the broader economy.
Why Earnings Matter?
At its very core, the value of a company is a function of its ability to generate future earnings (profits). As a company’s expected earnings increase, so should its value (stock price). If, in general, a company reports better than expected earnings or increases its future profit outlook, the company was likely undervalued and the stock should appreciate to reflect the improved expectation for future profits.
Entering the year, most indicators pointed to a favorable earnings environment. Fundamentals such as anticipated tax cuts, commodity prices, ISM (manufacturing) reports and technical factors such as momentum gave credence to higher earnings expectations (20% over prior year) as illustrated in the chart.
While the fairly obvious trend of investors setting expectations too high and revising downward throughout the year could be a subject for another update, the 2017 earnings season is off to a healthy start. Through February 17, the blended year-over-year revenue growth rate for the S&P 500 was 5%; its highest rate since 2012, should it hold.
Earnings expectations are high, results have been good, economic optimism is rising, but so are valuations. With the S&P 500 up 24.5% over the last 12 months and the Median Price/Earning Ratio hovering around 23 (compared to its median of approximately 17) stocks are not cheap. In addition, sentiment indicators and a potentially more restrictive monetary policy in 2017 provide cautionary signals.
Based on the environment, we are proceeding with a fairly neutral position on equities. In many cases significant overweights to riskier assets have been trimmed to more neutral levels since the beginning of November with profits being realized in the process.
While the earnings backdrop remains favorable, everything has a fair price and the expected headwinds are strong enough that, for the time being, we are not venturing too far out on the risk spectrum.