Q3 Earnings Season: It is show me time

With the D.C drama closer to a resolution (the markets think so), the attention over the coming days will shift to the 3^rd quarter earnings season, which is already underway.

More than any prior quarter in the last year, this earnings season (Q3 earnings) is more crucial for equity markets for a lot of reasons.  Why?

Earnings expectations: Coming into Q3 of this year (July-September Quarter), the expectation had been that: the US, and the world economies are re-accelerating; and hence, earnings and revenue growth for corporations should pick up as well. 

Hence, equity markets can withstand a "fed taper" without a deeper sell-off, if the economy is on a stronger footing and earnings start to pick up again. 

Reality: In the 3^rd quarter, interest rates have risen here, and around the world, and credit market conditions have tightened in a lot of emerging market (EM) economies. Additionally, a lot of the EM currencies have lost substantial value vis-à-vis the US dollar.  This has shown up in more caution and a lack-luster revenue picture from the earnings reports that we have seen so far for Q3. 

According this Reuters' story,  U.S. companies are warning about third quarter earnings at a rate lower than last quarter but still at the second highest level since 2001, leaving estimates well below what they were, just three months ago. Companies issuing negative outlooks for the quarter outnumber positive ones by 5.2-to-1, the most negative since the 6.3-to-1 ratio in the second quarter.

Earnings trends over last 2 years: Table below shows there is practically minimal growth (less than 1%) in the operating earnings for S&P 500 companies over last two years (as of June-end 2013)! 

Date	S&P 500 Index Value	Rolling 12-month operating earnings ($)	Operating P/E Ratio
6/30/2012	1362.16	98.69	13.80
6/30/2013	1606.00	99.41	16.16

And yet, the US equity indices have gone much higher, thanks to the fed’s liquidity operations. If the key take away from this (Q3) earnings season is -- a flattening trend in earnings/revenue growth and cautious outlook, it will likely be a head-wind for the equity markets.

This is not just our view: Here’s a commentary from a well-respected portfolio manager/strategist BYRON WIEN: I Am Worried about the Second Half Of 2013. 

Also, notice the Smart-Money Flow Index chart below, showing that the smarter money has been leaving the market since May, when the “taper” was first hinted, during the fed meeting. 

Source: Business Insider; Bloomberg

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[1] S&P 500 Index: The S&P 500, or the Standard & Poor's 500, is a stock market index based on the market capitalizations of 500 large companies whose common stock is publicly traded on the NYSE and NASDAQ Market.