As we noted in last week’s Earnings Update, rolling into the new October ’14 quarter this week, saw the typical jump in the forward-estimate from last week’s $125.56 to this week’s $130.02.

Given the traditional “roll”, last week we wrote that the new estimate would be somewhere between $129 – $130, and that in fact was the case. (If you’ve been reading this blog for a while, the bump shouldn’t have come as a surprise.)

The forward estimate p.e is now 15(x), and the PEG ratio is 2.72(x), which is a big increase from last week’s 1.76(x) and the consistent 1.6(x) – 1.8(x) PEG we’ve seen the last 8 – 12 weeks. (You’ll see why in a minute.)

The “earnings yield” on the SP 500 jumped to 6.61% this week, an increase from last week’s 6.34%, and is understandable given the -0.75% decline in the SP 500 for the week ended October 3, ’14.

What is puzzling and what can’t go unheeded is the sharp drop in the “forward 4-quarter” growth rate of the SP 500 from last week’s 8.95% to this week’s 5.57%.

We saw a similar circumstance from the last week of June ’14 to the first week of July ’14 when the forward 4-quarter growth rate fell from 8.75% to 5.40% and them immediately popped higher the following week to 8.53% as of July 11 ’14. Thus, I hate to trumpet the drop as a harbinger or warning sign of an impending 20% correction, until another week’s data is published. (Last week, I was hesitant to publish the jump in the forward 4-quarter growth rate for the same reason, since it was just one week’s data. However the annual 2014 full-year estimate hasn’t changed much and the data continues to indicate 9% – 10% full year EPS growth for the SP 500. )

Next week, Wednesday, October 8th, per the Thomson Reuters table, we get earnings from Alcoa (AA) and Costco (COST). Normally, we see JP Morgan (JPM), Wells Fargo (WFC) and GE (GE) in the first week Alcoa reports, but these companies are reporting the following week. (Long all of the above in varying weights.)

There is a lot of skepticism around q3 and q4 ’14 earnings right now.

Having done this for a few years now, analyzing earnings data is a bit reminiscent of the old fable about “The Three Blind Men and the Elephant”: depending upon which part of the elephant is being examined, each blind man has significantly different conclusions about what it is they have a hold of:

- If you’ve watched the drop in the SP 500’s q3 ’14 expected earnings growth just this quarter, from June 30 / July 1’s +11% to Friday October’s 3rd’s +6.4% you would conclude that there is some concern on the part of analyst consensus about upcoming earnings;
- If you watched the analyst estimate revisions during the prime reporting periods from the 2nd week of the first month of the quarter (January, April, July, and October), over the last few years, you’d think analysts in general remain positive about the future of the US equity market as upward revisions during the prime reporting periods continue to outweigh downward revisions to forward estimates;
- If you look at “bottoms-up” versus “top-down” earnings data, you’d get a different picture of SP 500 earnings, or you’d get an argument about forward valuation of the SP 500 and the “real” growth rate of earnings;
- If you simply looked at full-year annual EPS estimates, you could only conclude that the last three years the SP 500 has shown pretty consistent and stable mid-to-high-single-digit earnings growth every year;
- If you looked at earnings estimates by market cap, i.e. the Russell 2000 versus the SP 500, I think the two benchmarks would tell substantially different earnings stories;
- If you only looked at the SP 500 earnings growth for robust years like 1994 (+19%), 2011 (+15%) and 2013 (+6%) you’d be shocked to see SP 500 returns of 1%, 2% and 32% respectively. (Granted, I’m data-mining a little bit but the reader should quickly get the point);

For q3 ’14 SP 500 earnings, which are expected to start this week with Alcoa (AA), the drop from 11% to 6.4% is pretty normal, and per Thomson Reuters if the expected Bank of America charge is excluded, which is already in BAC’s q3 ’14 estimate, the expected q3 ’14 growth rate increases to 7.7%, which means that coming into q3 ’14 earnings season, a 7.7% growth rate is actually pretty decent (in my opinion).

The numbers tell me that q3 ’14 wont be that bad, even though there is a lot of concern about the dollar impact, Europe (look at Ford), South America, and such. (Long F, and BAC)

The most heavily oversold sectors today are Basic Materials and Energy. Here is the change in the expected earnings growth of these two sectors since July 1 ’14:

* Energy: *+6% (as of 10/3/14), vs. +13.8% as of July 1 ’14;

* Basic Mat:* +14.6% as of 10/3/14, +18.7% as of July 1 ’14.

If the SP 500 is expected to grow earnings 6% – 7% in q3 ’14 and both these sectors, particularly Basic Mat, are showing impressive relative strength in terms of earnings growth at a point during the quarter when expected sector growth is usually at its lowest, wouldn’t you think the sectors are oversold to the downside ? My own impression given the sentiment around these sectors is that the downward revisions, should have been much worse.

We’re underweight Energy and overweight Basic Mat in client accounts. (We have been underweight Energy for 2 years, which did hurt performance in calendar q2 ’14 but otherwise being underweight has been the right side of the trade. Energy underperformed in 2013.)

More to come on this topic tomorrow.

Thanks for reading. We seem to be a particularly uncertain time for the SP 500 and yet I think SP 500 earnings will continue to tell a positive story into year-end.

Trinity Asset Management, Inc. by:

Brian Gilmartin, CFA

Portfolio manager