Analysts and top corporate executives have become notably more bearish in recent months – are their views correct, and should we prepare for a bleak second-quarter earnings season? Join the debate here…

The second quarter is officially at an end; within a few days, we will be back in the midst of earnings season as, one after another, companies in the S&P 500 index report their results for the last three months. After ten straight quarters of higher rates of earnings growth, that rate of growth in profits reported by these companies began to slide in the fourth quarter of 2011. Analysts are predicting that the second quarter of 2012 will see an even greater decline in the rate of earnings growth; they have cut their forecasts for profits of S&P 500 companies over the last two months in light of growing array of signs of economic weakness in both Europe and the United States.

Will earnings growth be as dismal as these analysts predict, or is there room for hope that the analysts have been excessively bearish? Certainly, there is a school of thought that argues that one way for a company to post a positive earnings surprise in a difficult business environment is by downplaying its view of its upcoming earnings release. Or does the broad-based nature of these analyst downgrades reflect a very real anxiety about the outlook for corporate profits? That’s the question up for debate in the next in our recurring series of Point/Counterpoint features. Once again, AlphaNow will introduce two sides of an argument that is generating debate among investors, then invite you, our readers, to vote on which argument you find most compelling and contribute your own thoughts and opinions to the discussion.

POINT: As recently as mid-April, analysts were calling for earnings to grow 10% during the second quarter; today, that has been cut nearly in half, to a mere 5.8%. If that ends up being the lowest we have seen since the third quarter of 2009, just as the economy began to shake off the impact of the financial crisis. And that figure may overstate the real rate of profit growth, thanks to the outsize impact of Bank of America. During the second quarter of 2011 – the period against which the just-completed quarter’s results will be measured – Bank of America’s earnings were battered by the one-time impact of the $8.5B settlement of a lawsuit related to mortgage backed securities issued by its Countrywide unit. That means it’s going to be relatively easy for the bank to post what appears to be a big gain in earnings, without actually seeing nearly as significant an increase in its operating performance. Exclude Bank of America from the calculations, and the predicted rate of earnings growth falls to a mere 0.7%.

Moreover, it is striking to note that isn’t just analysts who are taking a bearish view of the upcoming earnings season, but the companies themselves. Although companies that choose to issue guidance are generally more cautious than the analysts covering them, this quarter they are unusually so. Companies in the S&P 500 have issued 95 negative preannouncements in the last four months, but only 29 positive preannouncements, resulting in a negative to positive ratio of 3.3. That’s the most bearish reading we have seen from this ratio since the fourth-quarter of 2008, as the economy was in the midst of the financial crisis. The breadth of the bearishness on the part of both analysts and the companies also is striking: only one sector has seen positive preannouncements by companies exceed negative ones, and that is telecommunications, which accounts for only 1.6% of the companies in the S&P 500. It’s also striking, as seen in the chart below, that the sectors that have been among those to deliver the biggest gains in earnings and that have contributed most to the recent double-digit gains in corporate profits – Financials and Consumer Discretionary – now rank among those that are most bearish.

COUNTERPOINT: While it’s true that analysts have turned bearish in the last few months that means it won’t take much for companies to post positive earnings surprises for the second quarter. And if you’re getting a sense of déjà vu, you’re right – we’re experiencing a very similar pattern to that we saw only three months ago. As you can see from the chart below, earnings growth estimates for first-quarter corporate profits nosedived ahead of the end of the quarter and the beginning of the reporting period. But as soon as companies began reporting their actual results, it quickly became apparent that analysts had become far too bearish: one after another, companies reported positive surprises.

There is no substantive reason to declare authoritatively that this pattern won’t repeat itself in the next few weeks, as companies begin disclosing their actual results. True, the outlook for the global economy has become gloomier – but that has had a depressing effect on the prices of key industrial commodities, as well, most notably on crude oil prices. While a more sluggish global economy may dent future corporate profits, lower raw materials costs will provide an immediate boost to the bottom lines of scores of S&P 500 companies. Admittedly, that’s bad news for energy and some utilities companies, but collectively they make up less than 10% of the S&P 500. Right now, the mood is bearish; it takes less to convince investors and analysts that there is something out there to worry about than it did at the beginning of the year. But there’s a reason why the phrase “climbing a wall of worry” has become a cliché: it’s true that when individuals are relieved to discover that their worst fears were a product more of their imaginations running amok than of anything substantive, it sets the stage for a rally.

THE VERDICT: As always, we’re leaving that in your hands. Which view of second-quarter profits do you find more compelling? Are you more encouraged that the bearishness of analysts and CEOs alike sets the stage for another flurry of positive surprises than you are worried about the impact on earnings of a slowdown in global growth? Is it premature to worry that a weaker global economy will result in the weakest earnings growth rate on record since the financial crisis? Or are we finally about to realize just how poor the outlook is for corporate profits? If you believe that the trend of positive earnings growth will continue, please click the button below labeled “bull”. If you think that difficulties in Europe will lead to a weak earnings season, click the button labeled “bear”. After you have voted, please tell us why: what factors weigh most heavily in your own analysis of the situation, and what do you think will happen over the coming weeks?

 
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