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Tuesday, January 7, 2014 - 14:30
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Tuesday, January 7, 2014 - 14:30

4 Key Themes To Track This Earnings Season

Tuesday, January 7, 2014 - 2:30pm

In the three months since Alcoa (NYSE: AA) kicked off the third-quarter earnings season, much has happened:

• U.S. consumers moved further into hibernation, leading to another period of weakness for major retailers (at least those not named (Nasdaq: AMZN)).

• The U.S. government botched a much-anticipated rollout of the Affordable Care Act, aka Obamacare.

• Natural gas prices surged to multi-year highs on the back of an unusually cold winter.

• Companies began picking up the pace of hiring, leading the Federal Reserve to begin tapering its stimulus program.

• And the S&P 500 Index delivered a 9.8% quarterly gain, which works out to more than 35% on an annualized basis.

With Alcoa set to once again kick off earnings season this week on Jan. 9, it's time to look ahead and ponder what the quarter ahead holds for investors. Here are four key themes you should be tracking as you digest the raft of quarterly conference calls set to take place over the next month.

1. More Buybacks And Dividends
One of the hallmarks of this bull market (which will hit the five-year mark in early March) is the clear preference for buybacks and dividend hikes over capital spending. In the 12-month period that ended Sept. 30, for example, companies bought back $448 billion worth of stock, according to research firm FactSet. That works out to be fully 68% of the free cash flow that companies generated in that period.

Indeed, levels of free cash flow -- and corporate profit margins -- have been so robust in large part because companies have been hesitant to make internal investments in the face of an uncertain economic outlook.

Yet the economy now appears to be moving onto a higher plane, with the prospects of 3% GDP growth coming into view. As a result, market strategists believe many companies will start to shift their focus away from dividend growth.

If you've been investing in companies that have been deeply committed to dividend hikes, you'll need to track their comments closely. "CFOs may change course in determining priorities, and dividends may not be as exciting as they had been," Citigroup analyst Tobias Levkovich predicts. He figures rising bond yields make the income production of stocks less alluring than it had been, and he expects a shift toward higher capital spending and further share buybacks.

2. Peak Margins?
Rising capital spending brings another concern for investors. Sean Darby, a market strategist at Jefferies, predicts that "companies are likely to raise their expenditure habits as the economy continues to improve. This should ultimately break the bull market since it will likely bring a contraction in margins and contraction in free cash flow." Few strategists are willing to publicly ponder an end to the bull market right now, especially since the S&P 500's 2013 gains blew past even the most optimistic forecasts.

A recent article in The Economist questions the wisdom of expecting continued profit margin levels. The authors note that "American profits are at a post-war high as a proportion of GDP," but add that "perhaps the revival in economic confidence might persuade executives that the time is right for expansion, and for more capital spending. Good news for the economy might then not be good news for investors."

This coming earnings season, you should closely scrutinize quarter-to-quarter trends in profit margins, which will give greater long-term insights then simple earnings per share (EPS) comparisons. Even if margins have not yet contracted, you'll want to listen in for clues about 2014 capital spending plans. Any big boosts will lead analysts to lower their free cash flow forecasts for the year.

3. Rest Of The World: A Tale Of 2 Markets
As I noted late last month, small-cap stocks have been especially strong in recent years partially due to the fact that they have greater exposure to the U.S. economy and less exposure to troubled foreign economies. Larger companies, with their relatively higher global exposure to Europe and emerging markets, haven't had it so easy.

Will those headwinds become tailwinds for blue-chip stocks? Automakers such as Ford (NYSE: F) and GM (NYSE: GM), for example, have been sharply cutting overhead across the continent, and although these divisions are not yet profitable, they are becoming a much smaller drag on profits. With Europe stabilizing, you may also hear more about cross-border investments as U.S. companies (and investors) seize upon relatively cheaper asset prices in Europe.

It does appear as if trading activity with some countries is beginning to surge. The Commerce Department just reported that exports in November hit a seasonally adjusted record $195 billion. China, Mexico and Canada have been the sources of U.S. export strength in 2013, and hopes are rising that Europe can help boost America's export picture in 2014.

The outlook for emerging markets is far murkier. Expect to hear about stiff sales headwinds in countries like Brazil, Turkey, South Africa and elsewhere. Not only are these countries seeing a deepening economic slump, but their currencies are tumbling as well, making U.S.-made imports that much more expensive, and leading to smaller profits when results are repatriated back into U.S. dollars. A possible slowing in the Chinese economy would simply spread even more pain across emerging markets.

4. Signs Of Revival Among The Laggards
Investors will be closely tracking the fortunes of the industries and sectors that didn't participate in the bull market of 2013. Commodity producers, retailers and homebuilders all finished the year on a weaker note than when the year began. Although these companies in these industries may not speak of an imminent upturn during the coming earnings season, investors will still start to gravitate to them if they see that business has stabilized and the longer-term prospects for a revival are in focus.

Risks to Consider: Earnings season has proved to be fairly boring in recent years, in large part because analysts set a low bar and subsequent results can look predictably impressive. But the U.S. economy is turning a corner, and the investment themes that have predominated previous earnings seasons won't hold the same resonance this time around.

Action to Take --> Don't conflate an improving economy with a bull market. As we've seen in recent years, stocks can rally for factors related to a weak economy. With the Fed in retreat, capital spending on the rise, the U.S. consumer in stronger financial shape, Europe turning the corner, and emerging markets battling the flu, this coming earnings season will have a lot of factors to digest. Take the time to listen to the conference calls of the stocks you own, or at least read the earnings transcript as soon as it is feasible.

P.S. Is it possible to tune out the mainstream money media, ignore the conference calls and earnings reports, say goodbye to your broker -- and still make money in the markets this year? The answer is absolutely. Our research shows that you can find a winning investment roughly 85% of the time and see returns of 18% in two weeks... 43% in nine months... and 58% in 11 months -- all while glancing at the market just 12 minutes per month. Go here to find out how... 

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.

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