What You Need to Know About the Fourth Quarter Earnings Season

Investing Daily Article of the Week

by Chad Fraser, Investing Daily

Fresh off the holidays, investors are turning their attention to the fourth-quarter earnings season, which unofficially kicks off Thursday afternoon, when No. 1 U.S. aluminum producer Alcoa (NYSE: AA) releases its latest results.

According to the latest figures from FactSet Research, of the 107 companies in the S&P 500 index that issued fourth-quarter earnings forecasts before the end of 2013, 94 (or 88%) had lowered them. That’s the highest total since FactSet started keeping track in 2006.

On the surface, that sounds worrisome, but a bit of perspective is helpful: the previous record was held by the third quarter (90) and before that, the second quarter (88), and prior to that, the first quarter (86). Meanwhile, the S&P 500 romped to a banner year, posting a 30% gain in 2013 — its strongest performance since 1997.

The disconnect between share prices and earnings expectations has fueled concern that stocks are overvalued and set for a correction. FactSet’s numbers give some credence to this, stating that the S&P 500’s 12-month forward p/e ratio stood at 15.4 as of December 31, up from 15.1 a month earlier and above the five-year (13.1) and 10-year (14.0) averages.

Even so, Investing Daily Editorial Director John Persinos feels concerns about a sharp drop are overwrought; he wrote in a December 10 Investing Daily article,

“Sure, the market as a whole is expensive and vulnerable to a pullback, but economic growth remains on track, and catastrophe is not on the horizon.”

“Even better, the shares of many high-quality companies are still available at reasonable prices. However, as this aging bull market approaches its fifth year, risk mitigation is more imperative than ever. The investment road from here requires vigilance, not undue fear.”

Buybacks on the Rise

Notably, companies themselves appear to see their shares as fairly valued: according to figures from S&P Dow Jones Indices, S&P 500 firms spent $182 billion buying back their stock in the third quarter of 2013, up 8.6% from the second quarter and 23.6% from a year ago.

Howard Silverblatt, senior index analyst at Dow Jones Indices, said in a December 23 press release

“Just keeping up with the current bull market means that companies have to pay 25% more for the same number of shares they repurchased last year. However, we are starting to see excess buying, where the repurchases outnumber the issuance, and therefore reduce the share count. The lower share count leads to higher EPS, and the market likes higher EPS.”

Buybacks, along with cost cuts and other margin improvements, are one reason why FactSet’s research points to a 6.3% increase in overall S&P 500 earnings in 2014, with revenue eking out only a 0.3% gain. In order for economic growth to take over as a main driver of earnings increases, revenue growth will have to accelerate in future quarters.

The Leaders: Financials and Telecom Services

In all, FactSet expects eight of the 10 sectors in the S&P 500 to report higher earnings than a year ago.

Financials are set to lead for the fourth straight quarter, with a forecast 24.1% growth rate compared to a year ago. Insurance is one bright spot within the sector, partly due to a weak year-ago quarter, when companies were dealing with Hurricane Sandy. It’s a similar story in the diversified financial services industry, where Bank of America (NYSE: BAC) and Citigroup (NYSE: C) are up against weak year-ago performances.

Telecom Services is expected to post the second-strongest earnings advance of all 10 sectors, at 14.1%. However, Verizon Communications (NYSE: VZ), a recommendation of our Personal Finance advisory, will account for more than half of that gain: America’s largest wireless provider is forecast to earn $0.61 a share in the fourth quarter, up from $0.45 a year ago.

The Laggard: Energy

At the other end of the spectrum, energy is expected to post a 7.8% earnings decline, mainly due to weakness in two subsectors: coal and consumable fuels, and oil and gas refining and marketing, which FactSet sees posting year-over-year declines of 97% and 59%, respectively.

As with telecom services, one company is expected to weigh heavily: Exxon Mobil (NYSE: XOM), the second-largest U.S. company by market cap, is forecast to report fourth-quarter earnings of $1.96 a share, down from $2.20 a year ago.

Beyond the Fourth Quarter

According to estimates from Bloomberg, the S&P 500 will rise 5.5% in 2014, which is obviously well down from last year’s surge. That forecast is also below the index’s 10-year average return of 7.4% but still well into positive territory and far above inflation.

Here are three things our Investing Daily editors are keeping a close eye on as we move further into the new year:

• Volatility ahead? Personal Finance chief investment strategist Philip Springer echoes Persinos’s call for investor prudence in 2014. That’s because even if stock market gains materialize as forecast, he doesn’t think it will be a smooth ride.

  Springer wrote in a January 3, 2014, Personal Finance article,

  “Volatility was low last year, as stocks maintained a steady upward bias, including no single day with a decline of 3%. Volatility fell largely because the Fed’s monetary policy dampened risk. Moreover, there was a surprising absence of significant negative economic, corporate or political developments.”

  “Notably, the markets correctly ignored Washington, D.C., and Europe was quiet. We expect more volatility this year.”

• Buyback bonanza to continue: As mentioned, corporate America continues to devote a huge amount of cash toward buybacks. Dividends are on the rise, too. Springer sees these trends continuing in 2014. He writes,

  “The big companies in particular have been able to borrow at low interest rates. For various reasons, they’ve also been generally slow to hire and expand their businesses.”

  “Those factors have made a lot of cash available to boost dividend payouts and repurchase the companies’ own shares. Both actions boost stock prices.”

• Europe on the mend: Investing Daily analyst Benjamin Shepherd feels the continent will continue to shake off the effects of the sovereign debt crisis and keep its nascent recovery going. He points out that European stocks generally kept pace with their U.S. counterparts in 2013, and that should continue this year.

  He wrote in a January 2 article,

  “Revenues at many European companies have been growing over the past year, and margins are generally expanding. Earnings also grew on average in the high single digits last year and are expected to outpace those of U.S. companies in 2014.”

  To be sure, risks remain, such as high levels of debt held by many countries, but growth should be supported by continued dovish policies by the European Central Bank, writes Shepherd, which will hold down the value of the euro, giving the continent’s exporters a competitive advantage.

  His conclusion?

  “While the U.S. economic recovery has become old news, Europe will likely be the real success story in 2014 and should gain momentum into 2015 as economic growth continues to accelerate. Don’t underweight emerging market stocks and certainly don’t dump the U.S., but Europe will be the big winner in the new year.”