Weekly markets commentary – October 12, 2009

David Joy — Chief Market Strategist, RiverSource Investments

All eyes on earnings

Third-quarter earnings season accelerates this week with a few unanswered questions.

Second-quarter earnings were well above expectations. In fact, a record percentage of companies produced positive surprises. Most of that outperformance came as a result of cost cutting, as businesses fought to maintain their profit margins in response to weak revenue growth. Of the 10 equity market sectors, only financials enjoyed a revenue increase.

But rewarding managements for cutting expenses is fine only for so long. Cost cutting is not a growth strategy. Sales growth will be required eventually to keep investors happy.

The question is how much revenue growth will we see in the third quarter and how will investors respond? For what few earnings reports we've seen so far, the answer seems to be that revenue gains will be rewarded, but so will bottom lines that surpass expectations even without top line growth.

According to Barclay's, companies that have so far beaten earnings per share (EPS) estimates have enjoyed a next session gain of 2.4 percent. Those beating on revenues enjoyed a 2.7 percent gain. In contrast, companies missing EPS estimates have declined 4.5 percent and those that only matched expectations fell 3.6 percent.

It appears then that investors will not be so insistent upon seeing revenue gains in the third quarter. Yes, that is good if we can get it, but cost cutting as a means to a better bottom line is still sufficient for now.

This response is consistent with the overall expectation of flat revenue growth compared to the second quarter. In other words, the bar has been set rather low.

It may be too early in the economic recovery to expect much by way of sales growth. But that sentiment may not last much longer. Revenues overall tend to rise a couple of quarters after earnings bottom. This suggests that as early as the fourth quarter the bar may be raised on revenue growth expectations.

Weak dollar

One potential source of revenue gains in third-quarter results might be the weakness in the dollar. The U.S. Dollar Index (DXY) was down by more than four percent in the third quarter and by more than 10 percent during the past six months. Companies with greater overseas revenue exposure may benefit. At the sector level, technology, energy, materials and industrials derive the largest percentage of revenues from overseas.

This week's reports from Intel and IBM should provide some insight into the overall tech sector results, just as Alcoa's report last week, that evidenced firming prices and rising overseas demand, is hoped to be indicative of the experience of the broader materials group.

Financials could see revenue growth again this quarter given the normalizing trend in capital markets. This week's reports from Goldman Sachs, J.P. Morgan Chase and Citigroup should answer that question.

Although it is still very early in the earnings reporting season, the aggregate results have been strong with 71 percent of companies beating expectations, only slightly below record second-quarter results of 74 percent. This was foreshadowed by a strong preannouncement season and by strong upward revisions ahead of actual earnings announcements.

Historically, much of the gains in stock prices from positive earnings surprise are discounted before the actual report. This phenomenon may be particularly important this time since markets have rallied strongly and investors are looking for the next upside catalyst. But history also has shown that stocks experiencing positive earnings surprises have tended to drift upward for some time after the announcement, meaning that a good earnings season could provide such a catalyst. Conversely, there isn't much argument that a disappointing earnings season could provide the catalyst for a move to the downside.

Economic reports

While earnings take center stage, there are several significant economic reports scheduled for release this week. On Wednesday, September retail sales are expected to decline owing to the expiration of the “cash for clunkers” program. Without that effect, sales are believed to have risen modestly.

Small increases at both the core and headline levels are expected from the September Consumer Price Index (CPI) report on Thursday. And on Friday, industrial production is expected to rise modestly for the third-consecutive monthly increase after eight straight months of decline.

Among other companies reporting earnings this week are Johnson&Johnson, Google, Bank of America and General Electric.