News Analysis date published New: 
Friday, April 8, 2011 - 13:00
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Thursday, August 15, 2013 - 11:09
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Friday, April 8, 2011 - 13:00

4 Things You Should Worry About This Earnings Season

Friday, April 08, 2011 1:00 PM

"Beat and Raise." The pattern of beating estimates and raising forward guidance has been the key theme in each earnings season of the past two years. This time will be different. The "beat" part will likely hold as companies and the analysts that follow them continue to play the game of low expectations that then get exceeded. The "raise" part? That just got much trickier.

Companies raise guidance when they have a lot of certainty about what the coming months will bring. Right now, few can say with certainty about how the wide range of domestic and global events will play out. Here's a checklist of the issues these companies face. Later on, I'll look at the potential impact on specific sectors.

  • Oil prices bring caution. Expect a number of companies, especially those that are focused on consumers or have high transportation costs, to express real concern about surging oil. Stressed consumers are in no mood to help shoulder the burden. For example, airlines had successfully pushed through six fare hikes since the start of the year. On the seventh try, consumers appear to have balked and airlines had to roll back that last fare increase. [My colleague Ryan Fuhrmann thinks, however, that some airline stocks could eventually double from current levels. Read his analysis here.]
  • Budget problems start to bite. If the government indeed gets locked down and remains shuttered while earnings season begins next week, then a wide range of companies that sell to the government are likely to dampen expectations for the second quarter. And investors may not shrug it off as just a temporary problem. Any final resolution of the budget deficit is likely to lead to lower government spending in a range of services, and companies will need to adjust their outlooks to a more challenging future.
  • Burgeoning inflation pressures. One of the downsides of a growing economy is the potential for demand to outstrip supply. Whenever that happens, prices rise as goods producers feel emboldened to push through increases. We're already seeing that happen in agriculture and commodity markets and the trend may spread to other industries if the economy keeps growing. As an example, Ford (NYSE: F) and GM (NYSE: GM) surprised analysts in the last earnings season by noting that rising steel prices are crimping profit margins. If steel prices rise higher, then profit forecasts may come under even greater pressure.
  • The Japanese luxury market softens. Many high-end U.S. retailers such as Tiffany's (NYSE: TIF) and Coach (NYSE: COH) have always counted on Japan as a key market. The current economic crisis may dampen demand as Japanese consumers appear to be avoiding life's little luxuries while their countrymen suffer. Of even greater concern, the Japanese yen has plunged in recent sessions and if it doesn't rebound, U.S. goods will become notably more expensive for Japanese consumers.

Yet real positives are also emerging that will lead some companies and industries to express even more confidence, including...

  • The weakening dollar. When the first quarter began, the dollar was worth about 1.32 euro. Now, we're up to 1.43 euros to the dollar and the move could continue. That's because European central bankers have begun the process of interest rate hikes to stave off inflation. If they keep doing so as the U.S. Federal Reserve stays put, then the euro will attract more investment seeking that rising yield gap. The dollar has also noticeably weakened against the British pound, the Australian dollar and the Swiss franc. A weaker dollar is generally good for U.S. multinationals that derive a good bit of revenue abroad, such as Procter & Gamble (NYSE: PG) and IBM (NYSE: IBM).
  • An improving employment picture. Barring any unforeseen events, the recently improving job trends are likely to remain. Once an expansion in employment begins, it creates a positive feedback loop as an ever-broadening range of industries respond to improved order flow from customers. For example, investments in capital equipment trigger hiring in the manufacturing sector. And when a local manufacturer boosts employment, a host of local businesses benefit as well, from the local deli to the local car dealership.
  • The "late-cycle" has begun. The first part of the economic expansion has mostly benefited large companies which tend to benefit from greater exposure to the global economy. Now, we're moving into next phase of the economic expansion, which starts to benefit small to medium-sized businesses, which I discussed here. For example, a family friend of mine is an executive at a leading cellar door manufacturer. He notes that business has suddenly turned up sharply in recent weeks and months. He had doubted stories about the economic recovery in 2010 but now he's a believer.

These positive and negative forces on the economy are bound to create a schizophrenic earnings season.

Companies that benefit from a weak dollar, a stronger U.S. consumer, or that have ample exposure to small- and medium-sized businesses could offer up very bullish sales and profit forecasts. This includes companies such as Deere (NYSE: DE), Kohl's (NYSE: KSS), lenders such as Wells Fargo (NYSE: WFC) and IT equipment vendors such as Ingram Micro (NYSE: IM).

Companies that feel the stress of rising oil prices, higher material costs, a weakened Japanese consumer or reduced government spending include FedEx (NYSE: FDX), Whirlpool (NYSE: WHR), Saks (NYSE: SKS), and Computer Sciences (NYSE: CSC).

Action to Take --> These aren't formal predictions of which companies will boost guidance and which companies will lower guidance. Instead, it's a roadmap for the factors that may drive stocks as earnings season gets underway next week. But you will want to watch these stocks. Make no mistake: stocks will only keep rallying as long as analysts continue to boost their profit forecasts. If the cycle of "beat and raise" appears to be winding down, then the market may finally have a real excuse for profit-taking.

P.S. -- Few investors realize that a 20-year energy agreement between the United States and Russia is about to expire. This deal supplies 10% of America's electricity. As broke as our government is, the situation is so serious that President Obama is asking for $36 billion to avert this crisis. And Republicans support him. Here's what's going on…

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.