Q2 Earnings Preview From Citigroup

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Second quarter earnings season officially kicks off on Wednesday with Alcoa’s report on tap. Analysts have been tracking preannouncements, consensus estimates and growth estimates for each sector, and the news is mixed.

Negative to positive preannouncements remain solid

Citi analysts Tobias Levkovich and Lorraine Schmitt pointed out that the ratio of negative to positive preannouncements has “moderated” since the first quarter. However, they added that the ratio remains above average, which of course is a positive sign for second quarter earnings. They cited a very interesting reason for the moderation in negative to positive preannouncements.

“It has become almost commonplace to see more negative preannouncements as management teams worry about potential shareholder lawsuits for not releasing material disappointment information early and thus, monitoring the data relative to trend is worthwhile,” they wrote in their “Monday Morning Musings” report.

They said the ratio slipped from the first quarter’s 4.5 to 4 for the second quarter, but it remains still well ahead of the long term average of 2.7. The second quarter preannouncement ratio is flat year over year.

Upside earnings surprises likely

Because the negative to positive preannouncement ratio is still higher than the average, the Citi team believes there is a higher chance of upside surprises because companies have set the bar for expectations quite low. They note that bottom-up consensus estimates suggest there will be a decline of 6% to 7% in earnings year over year, but they think it’s likely earnings will beat the consensus. Their own estimate suggests an increase of 2% year over year.

S&P 500 earnings

They said the significant decline in gas and oil prices year over year, plus the strengthening of the U.S. dollar are probably “restraining” trends in earnings per share. In particular, income for the Energy sector will likely plummet, widening from the first quarter’s 53% decline to a decline of more than 63% year over year for the second quarter.

S&P 500 earnings

Not counting the Energy sector, the Citi team said bottom-up estimates suggest “a very slight uptick,” although comparisons are probably not as easy in the second quarter as they were in the first quarter. The reason for this was severe weather in last year’s first quarter, which had a negative impact on the broader economy during the quarter.

S&P 500 earnings

Earnings growth estimates falling

This is now the second quarter in a row in which earnings per share growth estimates have been falling. Over the last three months, the Materials, Consumer Discretionary and Health Care sectors have seen a “modest” increase in earnings gains year over year.

S&P 500 earnings

Most of the other sectors saw sharp declines, particularly the Industrials and Information Technology sectors.

S&P 500 earnings

The Citi team reported that neither a strong U.S. dollar nor a “cyclical/ defensive divide” explains these conditions. The Financials sector has shown some weakness but right now isn’t the reason for the sharp drop-off in expectations for year over year earnings growth like it was between 2007 and 2010.

A bit of good news was forward guidance, which has improved a bit along with broader economic data. This suggests that managements are beginning to become more confident. Over the last few weeks, the momentum in earnings revisions did soften, however, which the Citi team said explains the pick-up in the ratio for negative to positive preannouncements.

In terms of revisions, Banks, Autos and Capital Goods have shown improvements in revisions. Retailing has also shown signs of life.

S&P 500 earnings

S&P 500 earnings

The sectors which are showing declines in revisions include Media, Materials and Pharmaceuticals and Biotechnology.

The analysts further said the numbers aren’t “spiking strongly to the upside” but added that there are signs of progress despite the ongoing issues in Greece and China. Most of the earnings in the S&P 500 are from U.S.-based companies, and the news flow on the U.S. economy is “most critical and supportive recently, the Citi team wrote.

U.S. equities should improve returns

The analysts expect returns on the U.S. stock market to improve along with earnings. The S&P 500 closed out the middle of the year in line with their target of 2,100. They believe their year-end target of 2,200 looks “sensible on the prediction of year-over-year progression, shifting from 1%- 2% in the first half of the year to about 8% in the second half of the year.

They expect stock prices to increase along with the Fed’s interest rates. However, they think share prices might not increase as much as the earnings per share trend because some investors could worry about compression of price to earnings multiples.

Here’s a look at how the sectors have performed year to date:

S&P 500 earnings

S&P 500 earnings

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