It's Earnings Season: Industrials and Tech Gain Traction

by Shawn Narancich, CFA Senior Vice President of Research

Earnings Central

Economic news was light this week, and what there was took a back seat to earnings. As we approach the midway point of second quarter earnings season, investors who were late to the equity party and were looking for cheaper admission remain confounded by a market characterized by a strong underlying bid. On balance, second quarter earnings have been positive so far, with most companies avoiding disastrous misses and again eking out profit gains through good cost control, share buybacks and modest underlying growth. That the U.S. stock market has become a consensus favorite despite sub-2 percent economic growth for the past three quarters is a testament to highly accommodative monetary policy and themes like the renaissance of U.S. energy production and the rebound in housing, both of which promise to deliver better GDP numbers in the second half of this year.

Shock and Awe

What strikes us most about the numbers so far are the trends by sector. While about two-thirds of companies are delivering earnings above estimates and half of those are generating better than expected revenue, the industrial and technology sectors are reporting the best numbers relative to expectations. That blue chips industrials like General Electric, Honeywell and United Technology are clearing the earnings bar is less surprising than the numbers delivered by defense companies, which Wall Street had widely expected to be weakened by the early innings of federally sequestered spending cuts. Much to our surprise, defense primes Lockheed Martin, Northrop Grumman, and Raytheon reported clean sweeps, exceeding top and bottom line expectations for the second quarter while also raising guidance. Multiple factors explain this paradox, including the fact that Pentagon cutbacks are still in their early days. More notably, the defense contractors represent “Exhibit A” in the manual on how to manufacture earnings growth—cut costs, repurchase shares and, if you are an old-line industrial with roots in the defined benefit pension era, recognize the earnings benefit that rising interest rates have on projected benefit obligations. Remarkably, the stocks of all three of these companies have outperformed the S&P 500 year-to-date.

Hall Pass Anyone?

In technology, it’s hard to emphasize the upside without highlighting Facebook, which blew away expectations for both revenues and earnings. Revenue growth accelerated to 53 percent in the quarter, defying skeptics who claimed that they would be unable to monetize an avowed shift to mobile advertising. As investors took notice of a remarkable 75 percent sequential surge in mobile ad sales, bears ran for cover and prompted a huge short squeeze in the stock. Facebook’s stock was an overnight success, surging 30 percent on immense trading volume that brought shares to within shouting distance of the company’s ill-priced IPO. While Facebook profits surged, disappointed investors by reporting a quarterly loss on slightly lower than expected revenue growth.  Nevertheless, Wall Street again looked the other way, seeing eventual riches behind the bounty of sales this web giant continues to amass. Despite management telling investors to expect another loss in the third quarter on lower than expected sales, shares rose 3 percent.

Green Shoots

Earnings remain front and center, but we would be remiss not to mention the change at the margin that we perceive in Europe. While the Continent has been plagued by recession for two years now, increasingly easy monetary policy and reduced emphasis on fiscal austerity appear to be germinating some green shoots. A broad mid-month survey of manufacturing activity there rose above 50 this week (the dividing line between contraction and growth), consumer confidence is up, and a handful of companies are reporting that their European business isn’t quite as bad as it was. In a world of 12 percent unemployment and weak export markets, it wouldn’t take much of a spark to move Europe’s GDP needle back into positive territory.

More Where That Came From

Next week brings another huge wave of corporate earnings reports, including bellwether reports from ExxonMobil and Chevron in the energy sector. In addition, the economics calendar ramps up, with the July employment report Friday preceded by what will be investors’ first look at second quarter GDP here in the U.S. on Wednesday. Finally, investors will scour reports from the Fed, which will meet again on Tuesday and Wednesday to review monetary policy and perhaps give additional clues about its plan to reduce the size of QE.

Our Takeaways from the Week

  • Equities finished a busy week of earnings largely flat, with industrials and tech companies providing the most encouraging results
  •  Europe’s recession appears to be waning