Earnings season traditionally begins with Alcoa (AA), which has announced its quarterly earnings call will be on October 8th. The aluminum producer is sometimes seen as an indicator of demand more broadly, but competition and supply issues in its sector make that correlation looser at some times. In 2014, the stock has soared for a 50% gain due mostly to issues related to the business itself, although its earnings tomorrow will be looked at closely by analysts who are looking for a sign of broader economic trends.
The broad trends do not look good. The IMF has cut its growth forecast, citing the “legacies of the pre-crisis boom and the subsequence crisis” as a headwind to growth, while emerging market demand is expected to decelerate to rates lower than the pre-crisis norm. In total, the global economy will grow 3.8% in 2014, the IMF said.
Investors, especially in the equity market, don’t bet only on global growth trends. Also crucial are the trends within each company. Companies can outpace that growth if they are in a sector that is seeing rising demand, or they can outpace it by stealing market share from competitors. Additionally, they can deliver more shareholder value by buying back shares, increasing dividends, and cutting costs.
Therefore, looking at macroeconomic reports isn’t enough, although it’s a good start. Now when considering how to allocate capital in a portfolio, analysts need to look at how EPS are trending in the equity markets they are targeting.
For investors eyeing the American market, the P/E Ratio of the S&P 500 (SPY) is a starting point to determine how much growth the equity markets have ahead of them. Throughout 2014, that number has risen to the psychologically important 20 level, but has pulled back before reaching it several times throughout the year. Currently, it’s at about 19.3, up from 18.2 at the beginning of the year.
As a ratio of earnings to stock price, companies can improve the P/E ratio of their firms by buying back shares or cutting costs, which has been largely how companies kept earnings growth momentum from 2009 to today. As a result, the Buyback Achievers (PKW) have outperformed since the global financial crisis relative to SPY, but that delta (difference in performance) has reversed in 2014, as the overall market outperforms buybacks specifically.
That is largely due to changes in monetary policy and growth trends in the United States, which investors believed would result in less cheap money for stock buybacks and a heavier reliance on topline revenue growth. But revenue growth depends on aggregate demand, which in turn relies on aggregate demand growth. If the IMF is right, that improvement in demand is not forthcoming in the short term.
Therefore, investors might take a look again at dividends, cost cutting, and buybacks in this earnings season. Key metrics depending on cash flow will face greater scrutiny. Expectations around long-term Treasury yields, which relate to corporate debt interest rates, will become a greater focus. More than anything else, any sign of accelerating revenue growth will be a key driver in more investment in equities.
Every earnings season is important when you’re in the market, but some earnings seasons are more important than others. With monetary policy changing and the S&P P/E 20 barrier nearing, this earning season will be especially important.