3rd-Quarter Earnings Season: What To Watch For

StreetAuthority Network

Throughout the summer, investors were treated to a steady drumbeat of sobering news.

Retail sales were flattening out. China and other emerging markets appeared set to consume less of our exports. The steady implementation of the budget sequester was leading to a drop in government spending on technology and services. And many companies showed a lot more interest in buybacks and dividends than capital spending, which is a sure a sign of CEO pessimism.

So how do you explain the surprisingly robust profit picture being delivered in the current earnings season? 

With roughly 40% of the S&P 500 weighing in thus far (and another 25% to go next week), 68% of all reporting companies have delivered a positive earnings surprise, according to Standard & Poor's. That compares with just 18% of companies reporting negative surprises. Frankly, I wouldn't have been shocked if those numbers were reversed. The odds against yet another stellar earnings season seemed quite long.

Year-over-year comparisons tell the story. Among companies in the S&P 500 that have reported third-quarter results thus far, profits are up 8.4% from a year ago, more than triple the expectations of 2.5% for these companies. The profit gains are coming on 3.3% annual sales growth (from the third quarter of 2012), which tells you that companies are once again finding ways to boost profit margins.

The key driver of those margins: productivity gains, as companies are able to produce higher output with a fixed base of employees and assets. Rising productivity is a great sign for the economy; it was the key reason for the economic boom in the 1990s.

But this isn't the '90s, not by a long shot. Today's stiff headwinds are quite real. Out in the real world, many will tell you that the economy feels lousy. Retailers are bracing for a tepid holiday season after lackluster back-to-school sales. And even as corporations report solid profits, few have discussed plans for major investments in capital expenditures, which is the real driver of future economic growth.

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Another contrast with the '90s: Back then, much of the job creation and dynamic economic activity was fueled by small businesses. These days, the action squarely resides with already large companies that are simply growing yet larger.

Amazon.com (Nasdaq: AMZN) is a great example. Its shares surged nearly 10% on Friday to another all-time high as its North American sales grew a whopping 31% from the third quarter of 2012. The fact that Amazon is "still in the very early stages of international development," according to Benchmark Capital, explains why this company is expected to keep growing at a meteoric pace. 

But Amazon creates a huge conundrum for investors. Its stock valuation bears no relevance to current measures such as cash flow or profits. So investors are asked to focus on the company's impressive operational execution -- and to simply ignore traditional valuation measures.

And Amazon's numbers don't signal a revitalization in consumer confidence. Instead, the company is simply stealing market share from other retailers in a zero-sum game. In the fiscal fourth quarter that begins in November, Macy's (NYSE: M), Kohl's (NYSE: KSS) and Target (NYSE: TGT) are all expected to post modest revenue drops.

The Next Month Is Crucial
Roughly a month from now, you'll start hearing a lot about the outlook for 2014. Market strategists will be doing their best to determine whether 2014 will be yet another year of stellar profit growth -- or whether this four-year profit surge is set to wane.

So they'll be looking closely at the profit reports and economic reports that have yet to roll in. Over the next two weeks, the rest of the S&P 500 will weigh in, and we'll also start to hear from small and mid-cap stocks. As noted earlier, much of the recent economic activity seems to be benefiting the largest companies. The most recent report from the National Federation of Independent Businesses (NFIB) showed a modest drop in part due to a "significant increase in pessimism about future business conditions."

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We're also going to start seeing how the recent government shutdown impacted the economy. In just the coming week, expect new reports on:

-- industrial production (Monday)

-- pending home sales (Monday)

-- consumer confidence (Tuesday)

-- the Chicago Purchasing Managers' Index (Thursday)

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Risks to Consider: The economic risks noted earlier are still present, though the market has simply shrugged them off. Many have suspected that the Federal Reserve's massive stimulus program has pushed any economic concerns aside as liquidity simply flows into speculative assets such as stocks. But the solid third-quarter earnings season -- so far, at least -- means that it's not a purely speculative rally. Keep a close watch on the economy in coming weeks and months as you start to get a grasp out on the outlook for 2014.

Action To Take--> The whole backdrop of strong profit growth (for the largest firms) and a still-weak economy creates a very complex environment for investors. Focusing on high-growth stocks has been a winning strategy, but the still-weak economy should be favoring value investing.

Trying to play both flanks, focusing on GARP (growth at a reasonable price) has been quite challenging. In light of that, and despite this impressive earnings season, it still pays to maintain a slightly defensive posture in your portfolio, even if that means missing out on some of this extended bull rally.

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