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How Second Quarter Earnings May Affect The Stock Market

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Why Second Quarter Earnings Matter For The Stock Market

Second Quarter Earnings
With second quarter earnings season upon us, it is time to take a look at second quarter earnings to assess how they may affect the stock market.  While many factors affect the stock market’s current level and future direction, corporate earnings are what ultimately drive the stock market both higher and lower.  Rising corporate earnings are something a bull market needs to sustain itself.  With the current bull market in its sixth year, it needs continued corporate earnings growth to continue its upward trajectory and avoid a nasty sell-off.  That is why every trader and investor should take a close look at the coming quarterly earnings, as they will provide an indication of where the stock market is heading over both the near and medium term.

Where Things Stand Going Into Second Quarter Earnings Season

First off, it is essential to assess where the stock market currently stands going into second quarter earnings season, which officially kicks off July 8, 2014, with the release of Alcoa’s (NYSE: AA) second quarter earnings report.  As of early July 2014, the current average Price Earnings Ratio (P/E Ratio) for Standard and Poors 500 (S&P 500) stocks is slightly above 19.  This average S&P 500 P/E Ratio level is concerning, since it is approximately 25 percent higher than the long-term P/E Ratio for S&P 500 stocks of slightly above 15.

Quarterly Earnings

This means that if second quarter earnings and earning outlooks do not meet or exceed expectations, the stock market will be vulnerable to a sell-off.  With stocks valued approximately 25 percent higher than their long-term S&P 500 P/E Ratio valuation average, since any such sell-off could be rather steep.  Current quarterly earnings and earnings projections have to come in as expected or beat expectations to justify the current S&P 500 P/E Ratio of 19, since traders and investors are assuming that buying stocks at currently high P/E Ratios is justified by future earnings growth that will bring them back down in line with the long-term S&P 500 P/E Ratio average just above 15.

The good news is traders and investors are unlikely to be disappointed by second quarter earnings.  Wall Street analysts are expecting S&P 500 stocks to experience 6.6% earnings growth in the second quarter of 2014.  If this comes to pass, it would be an increase of one percentage point from the 5.6% earnings growth reported by companies during the first quarter of 2014.  Of the few S&P 500 companies that have already reported second quarter 2014 earnings, two-thirds have beaten analyst earnings estimates.  If this beat rate were to continue throughout the second quarter earnings season, it should provide an impetus for the stock market to rally.

Second Quarter Earnings and How They May Affect The Stock Market

What will ultimately drive stock prices higher and allow the bull market rally to continue during the second quarter earnings season is the outlook for futures revenue and earnings growth that companies provide during their second quarter earnings reports and conference calls.  One mistake that traders and investors sometimes make is putting too much emphasis on the current earnings quarter.  While blowout earnings can certainly cause the stock market to rally, they are backward looking.  In most cases, stock market participants look to future earnings projections, and bid up stocks based on what companies say about their earnings guidance for upcoming quarters.

Increased Earnings
Should stock traders and investors be optimistic about future earnings projections going into the 2014 second quarter earnings season?  Company Chief Executive Officers (CEOs) appear to be more optimistic about the United States economy’s growth prospects for the second half of 2014, which should translate into positive earnings projections for the second half of the year and most likely a higher stock market.  Given the rising optimism from the heads of corporations and signs that the United States economy is emerging from a lackluster first quarter, traders and investor can optimistically assume that many second quarter earnings reports and conference calls will include rosy future earnings projections for the remainder of 2014.

The S&P 500 sectors that are expected to report the highest rate of earnings growth during the second quarter earnings season include energy (+11.3%), materials (+11.6%), technology (+12.4%), and Telecom (+9.2%).  There are two sectors that are expected to lag the overall market and report negative earnings growth.  These include utilities (-0.5%) and financials (-1.8%).  While these positive and negative earnings growth numbers for the second quarter may not mean much to long-term investors who are invested for the long-run with investment horizons looking out decades, for traders, the positive sectors should be overweighted to profit from short-term price moves in stocks associated second quarters earnings announcements.

The Quarterly Earnings Bar Is Routinely Set Low

Something that savvy traders and investors understand about quarterly earnings for S&P 500 companies is that companies and analysts that track their earnings prospects routinely revise their earnings projects downwards as an earnings season approaches, lowering the bar that companies have to get over to beat quarterly earnings.  This has the effect of creating a lot of upside earnings surprises, which can be good for short-term stock market rallies, but must be taken in the context of long-term earnings growth rates to properly evaluate whether or not reported earnings were actually healthy or not for a particular quarter.  This is why the stock market often rallies during an earnings season, and then sells off somewhat after an earnings season has ended, as investors get a chance to digest the context of the recently reported quarterly earnings.

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