Earnings: Where the Q2 Surprises Could Be

The pullback in equity indexes on July 2 in response to the larger-than-expected drop in June nonfarm payrolls shouldn't have been a surprise, as light preholiday trading probably exacerbated the data-driven sell-off. But the disheartening employment snapshot doesn't necessarily bode any worse for second-quarter corporate earnings than what most investment strategists and economists were already anticipating.

Earnings for the companies in the Standard & Poor's 500-stock index are expected to be down 35.5% in the second quarter from a year earlier, according to the July 2 report by the Thomson Reuters (TRI) Proprietary Research Group. Earnings season is scheduled to start with Alcoa (AA) reporting results on July 8. The biggest year-over-year declines in profitability—a 79% plunge—is expected in the materials sector, which shouldn't surprise anyone who has followed the deterioration in the housing and commercial real estate markets.

Thomson Reuters' highest earnings forecasts are for a 2% decline for the health-care sector and a 6% drop for consumer-staples companies. A 29% decline is projected for consumer-discretionary companies.

The fact that 467,000 jobs were lost in June—100,000 more than the market expected and a substantially bigger decline than in May—disappointed those who assumed the pattern of diminishing job losses since the January peak would continue. But Art Hogan, chief market analyst at Jefferies & Co. (JEF) in Boston, says the huge drop from 741,000 jobs lost in January to 345,000 in May "set us up for disappointment."

It doesn't surprise Hogan that companies are reluctant to hire new workers until they see significant improvement in the economy. But he doesn't see a clear tie between the magnitude of continuing job losses and earnings. "It's anybody's guess whether we're down 34% year over year for the second quarter or 24%. I think we're positioned to have some upside surprises," though that may not be enough to ensure further upside to stock prices, he says.

Setting the Second-Half Bar Low

The near-absence of pre-announcements from companies over the last three or four weeks suggests the results will be fairly good, says Phil Orlando, chief equity market strategist at Federated Investors (FII) in New York. But he says he's not expecting much positive guidance for future quarters from corporate managers. "There's no reason for them to do so" in the current environment, he says. "It's better to set the bar as low as you possibly can and manufacture a positive upside surprise in the third or fourth quarter."

Reporting higher profits later this year shouldn't be too hard if the recession is about to end and positive economic growth returns in the third quarter, as Federated believes will be the case.

Mickey Cargile, managing partner at WNB Private Client Services in Midland, Tex., believes the economic recovery will be protracted, with plenty of data along the way to "test our resolve as investors." The June payroll number was one pitfall, "not so much the report itself but how long before those people go back to work," says Cargile. "The longer people stay unemployed, that's when it will trickle down to earnings," by keeping a lid on consumer spending while driving up foreclosures. Cargile thinks unemployment will peak sometime within the next six months but he expects the subsequent decline in the jobless rate to be a slow process.

Certainly, additional job losses and higher unemployment won't be good news for bank earnings any time soon. Unemployed people will try to live off their credit cards for a short time after losing jobs, which should lead to continuing increases in credit-card charge-offs by banks, says Jaime Peters, a bank analyst at Morningstar Funds (MORN) in Chicago. For all the incentives the government is providing to compel mortgage servicers to restructure loans, "if the reason a person can't pay the loan is they lost their job, no modification is going to work. They'll be foreclosed on," she says.

What About Bank Provisions?

The key question for earnings is whether banks will set aside more capital as provisions to cover potential future losses on assets, Peters says. Until now, banks had been provisioning from 60% to 100% more than what they were actually writing down, but she wonders whether provisions could start coming down even though charge-offs will rise. Any decline in provisions would bolster a bank's bottom line.

Thomson Reuters expects second-quarter earnings for the financial-services companies in the S&P 500 to come in 52% lower than a year ago. But a number of strategists see more potential for positive earnings surprises in that sector than any other, just because of how conservative analysts' forecasts are.

Robert Patten, an analyst at Morgan Keegan in New York, believes bank earnings will be "pitiful," but he expects net interest margins overall to widen, and to expand materially for some banks, "driven by very low-cost deposits, which are funding loans being renewed at much better spreads." Two years ago, competitive pressure forced banks to make loans at the London Interbank Overnight Rate (LIBOR) plus 1%, while they are now able to get LIBOR plus 2% to 3%, he says.

Patten expects provisions for potential future losses to go up as regulators force banks to take writedowns on commercial real estate assets and raw land. That's a result of all the pressure on the real estate appraisal industry due to lawsuits for having inflated property values, he says.

But over the longer run, he thinks rising interest rates will help generate better pretax, pre-provision earnings, "which will help banks earn their way through a very challenging credit cycle."

Another source of increasing revenue for the latest quarter will have been strong capital markets—not only fees earned from managing equity issuance by other banks, but money earned from trading in their fixed-income businesses, says Patten. "With all the volatility, there's been tremendous profitability" in trading agency paper and corporate bonds, as spreads between these bonds and U.S. Treasuries have held up fairly well. Banks' mortgage businesses should also have contributed generously to earnings, given the last rush of refinancing activity by borrowers trying to get in before interest rates ticked up.

Bracing for a Tech Pothole

The technology sector, one of the best performers during the economic downturn, has potential to disappoint, if only because of how aggressive analysts' earnings estimates have been, says Uri Landesman, chief equity strategist at ING Investment Management.

Thomson Reuters expects a 24% drop in earnings for tech companies in the S&P 500.

"People will be watching tech very closely," especially since some see it as a leading indicator for the economy as a whole, says Landesman. While technology may not have the most potential for downside surprises, "it's one where negative earnings surprises could cause a lot of damage," he says.

Ryan Jacob, manager of the $35 million Jacob Internet Fund (JAMFX), disagrees, saying "my feeling is you'll have more [tech companies] exceed expectations than falter."

One reason technology companies have done so well so far this year: They have cut their expenses to such an extent, starting last year, and delayed capital spending that it's now beginning to show up on their bottom lines, says Jacob, who believes the trend in significant earnings increases for these companies will continue.

The best results will continue to be reported by such companies as Red Hat (RHT), which focuses on open-source software, and Salesforce.com (CRM), which offers software as a service. Both business models are doing well because they entail significantly lower upfront costs than traditional software and are much more flexible and attractive to business customers, Jacob says.

Jacob says he has stayed away from large-cap technology companies like Intel (INTC) and Microsoft (MSFT) because it's very difficult for them to outperform the overall economy and they are most at risk from many of the smaller upstarts.

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