Change at the Earnings Margin


by Shawn Narancich, CFA
Executive Vice President of Research

More Than Meets the Eye

Relatively modest losses in the S&P 500 this week masked enormous volatility in the pricing of underlying companies, thanks to a deluge of third quarter earnings reports that resulted in what felt like a feast or famine result for individual stocks. This last full week of October marked the apex of earnings season for blue chip equities, and from a 30,000-foot view, companies are once again clearing the expectations bar they are so instrumental in setting. With nearly half of the S&P 500 having reported, about 75 percent of companies are clearing the earnings bar, which in turn means that Q3 ’16 also stands to represent the first quarter of the past six in which earnings will not have declined. Higher oil prices and less onerous dollar comps are helping equities demonstrate the earnings follow-through necessary to justify their year-to-date gains.

Earnings, Plus or Minus

While index earnings numbers are improving, investors have endured a gauntlet of company-specific earnings reports that have kinged some positions and left others staggering under the burden of dashed expectations. Amazon falls into the later camp, having missed earnings and guided fourth quarter numbers below Wall Street expectations – while people enjoy getting their Amazon deliveries quickly, shareholders are footing the bill for the cost of fulfillment. For a company trading at 152x expected earnings, we would count Amazon investors fortunate to have only lost 5 percent on Friday.

Google, meanwhile, is demonstrating that mobile devices can in fact pad the company’s bottom line, as more consumers access their search linked advertising on iPhones and Android devices. The stock gave up some of its earlier gains on the encouraging earnings, but finished in the black to conclude the week. In contrast, Chipotle Mexican Grill investors suffered a bout of indigestion after stomaching news of quarterly earnings that plummeted by 83 percent. The stock sank by 10 percent as it became clear that the fresh Mex restaurant operator has yet to staunch the traffic declines caused by its food safety issues revealed earlier in the year.

Finally, in the industrials realm, investors came to appreciate that a good defense can result in a good offense. Defense as in the defense industry, where strong numbers from prime contractors Lockheed Martin and Northrup Grumman at a time of inflecting US budgets lined the pockets of shareholders – Northrup up 6 percent and Lockheed up 7 percent on the week.

Did Somebody Say Inflation?

Aside from earnings, investors contended with a benchmark 10-year Treasury bond that continued to decline, with yields rising from 1.73 percent to 1.85 percent this week. Amid rising oil prices and some sporadic wage gains in the service industries, investors seem to be discounting a higher inflation premium ahead of what we expect will be the Fed’s first rate hike of the year in December. Economic data this week failed to dissuade investors from expecting this outcome, as the government’s first estimate of third quarter GDP was reported at 2.9 percent growth. While this headline number is the best we’ve seen in a couple years, the underlying detail shows an economy growing at closer to a 2 percent rate, this after removing a 0.9 percent boost from, of all things, soybean exports. When adjusted for exports and inventory effects, real final sales for the U.S. economy expanded by just 1.4 percent. We would observe that while the U.S. economy continues to grow, the expansion remains tepid.

Our Takeaways for the Week

Investors endured a tumultuous week of earnings in which stock indices declined modestly

Benchmark interest rates are rising as investors discount higher rates of headline inflation