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  • We'll see the pace of third-quarter earnings reports increase beginning this week.
  • Financials are expected to have the biggest year-over-year earnings decline because of rising loan loss provisions.
  • Energy stocks should post remarkable earnings growth despite a recent slide in commodity prices.
  • Technology earnings are estimated to fall, partly because of a strong U.S. Dollar.

We will get third-quarter earnings updates from 66 S&P 500 companies this week, kicking off this quarter’s earnings season in earnest. How earnings shaped up last quarter and what management says about future quarters will influence analysts' forward EPS revisions, impacting price-to-earnings ratios, making it a critical few weeks for bulls and bears.

For instance, commodity prices eased in the third quarter. Will that offset rising costs elsewhere, creating a sequential margin improvement? In addition, the Atlanta Fed’s GDPNow estimate is for third-quarter growth of 2.8%, following two consecutive quarters of negative GDP. Did a rebound in economic activity offset headwinds caused by negative real wages? 

If not, and earnings slid (again), and management outlooks disappoint (again), the S&P 500’s forward P/E ratio may overstate how cheap stocks are. According to FactSet, the S&P 500’s forward P/E is 15.5, below the 17.1 average over the past ten years. However, if revisions take 2023 estimates lower, the P/E will climb, even if prices remain near current levels.

For this reason, tracking specific industries for clues will be particularly important.

All eyes on banks

In “Earnings Season Is Front and Center,” Action Alerts PLUS co-Portfolio Managers Bob Lang and Chris Versace write:

“This week sees third-quarter earnings getting into full swing as banks continue to report, but as the volume of reports increases, so too will the number of other industries represented. Those reports, along with renewed geopolitical tension, are poised to be the central focus for investors given a relatively quiet week of economic data ahead…key areas of focus will be on end market demand, inflation pressures, supply chain issues, dollar headwinds, and cost-cutting efforts.”

Banks are among some of the first companies to report third-quarter financials, and the group will be watched closely for clues as to whether businesses and consumers are feeling strained.

Analysts expect earnings at financials fell 16.2% in the quarter, the worst year-over-year earnings performance of all the major S&P 500 sectors. In addition, estimates are that bank earnings fell by 13% from one year ago, as higher provisions to protect against customer defaults more than offset the positive impact of higher loan rates and lower funding costs (net interest margin).

Financials report loan loss provisions as an expense, which takes a toll on earnings. Last year, the industry benefited from lower provisions because of a strong economy and healthy consumer balance sheets. This quarter, FactSet estimates the 18 banks in the S&P 500 will set aside $6 billion in loss provisions. Last year, they were able to release $4.9 billion from reserves, so this quarter could represent nearly an $11 billion swing from one year ago.

Back to Lang and Versace:

“So far, bottom-line results from banks have been stronger than expected thanks to higher net interest income following the Fed's interest rate hiking efforts earlier this year. However, the growing concern is the pace of new loan growth, given the expected speed of the economy and rising loan loss reserves that would cover potential bad loans.”

We heard from J.P. Morgan  (JPM) , Wells Fargo  (WFC) , Citibank  (C)  last week, and Bank of America  (BAC)  today. Revenue grew year-over-year at all four, but earnings fell. JP Morgan reported diluted EPS of $3.12, down from $3.74 last year. Wells Fargo's diluted EPS was $0.85, down from $1.17.  Similarly, earnings declined 24% at Citibank and 5% at Bank of America. Nevertheless, so far, shares are up since each of their reports.

Focus on energy and technology earnings too

The biggest expected tailwind in S&P 500 earnings this quarter is expected from the energy sector. Despite a sequential dip in fossil fuel prices in Q3, prices are still up nicely from last year. As a result, energy stocks revenue is expected to increase by 33%, and EPS should climb by 119%.

We shouldn’t ignore the impact of energy on the S&P 500 third-quarter earnings outlook. S&P 500 earnings, including energy, grew by 1.6% in the past year. However, excluding energy, S&P 500 EPS likely fell by 4.9%.

Investors should also focus on technology, given it still represents a third of the S&P 500’s holdings, making it the largest S&P 500 sector by far by sector weight.

Back to Lang and Versace:

“Semiconductor capital equipment companies ASML  (ASML)  and Lam Research  (LRCX)  will not only shed light on how well demand for their products is holding up but what the fallout is from the White House's efforts to curb China's access to chip technology. Following the recent guidance cut at Applied Materials  (AMAT) , a position we exited near $90 roughly a month ago, odds are those two companies will have more of the same on tap… 

When Netflix  (NFLX)  reports, the focus will once again be on gains in its subscription base. Additionally, investors will be looking for details on what's expected for its new ad-supported plan set to debut on November 3rd and its new advertising revenue stream. Those comments will factor into expectations for others targeting similar revenue opportunities, ranging from Amazon  (AMZN)  and Apple  (AAPL)  to Disney  (DIS)  and Alphabet  (GOOGL) , but also companies like Snap  (SNAP) , which reports this week.”

This year, technology has been under considerable pressure partly because of the rally in the U.S. Dollar. As the dollar has increased relative to other currencies, it's causing an unfavorable impact when companies convert sales overseas back into dollars. According to Goldman Sachs, technology is the most exposed sector to foreign sales, with about 59% of revenue coming outside the U.S.

For perspective, companies in the S&P 500 with greater than 50% of revenue outside the U.S. are expected to see EPS fall 1.4%. Companies with less than 50% of sales coming from international markets are expected to see EPS rise by 3.5%.

Overall, FactSet says third-quarter technology earnings will decline by 4.5% year over year, a bit worse than the 3.8% consensus analyst outlook at the end of September.

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The Smart Play

Gaming earnings results is tempting because, every quarter, companies move by double-digit percentages up or down based on results. However, buying or selling ahead of earnings is a risky game, especially given this year's uncertainty. If you bet wrong, you could lose money quickly. Remember, this year’s sell-off means plenty of trapped investors are eager to sell if a stock pops or breaks down.

Similarly, if you short a stock ahead of an earnings report expecting a whiff, and the company beats, the higher-than-usual short interest could cause an eye-popping squeeze. Frankly, gaming EPS in this manner is a crap shoot. Remember, stop losses only work during regular market hours.

Instead, focus on what companies say about their business and then think three-dimensionally about what that may mean from here. For example, are companies announcing more or fewer layoffs? If so, what’s likely to happen to default rates at the credit card issuers or revenue at payroll processors? Are companies reporting higher or lower levels of inventory? If so, what’s that mean for transportation and manufacturing stocks? More broadly, if earnings results are better or weaker than expected and forward revisions to next year’s earnings change, what will it mean for investors’ valuation models?

A final word of caution. Because we’re in a bear market, earnings season could provide a lot of fodder for hyperbole, so try to keep your emotions in check as much as possible. 

There are likely to be a lot of curveballs, so don’t chase. Instead, proactively plan your trades, and trade your plan. For instance, do you know what you’ll do ahead of time if a company misses or beats expectations? Do you have targets for buys and sells predetermined? Making decisions at the moment is hard, so deciding things like this beforehand is key.

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