Low Expectations and Good

Low Expectations and Good

  15 Jan 2019

The next earnings season is set to kick off next week, and this could be a critical round of earnings for the market. Stocks fell sharply in the fourth quarter and seem to be trying to bounce back at this point. If the bounce is going to continue past a few days or a few weeks, corporate earnings are going to play a critical role.

Something that might help stocks is that the expectations seem to be lower heading in. That observation is based partially on facts and statistics and partially on reading the tone in financial media.

The other morning there was a guest on Bloomberg that was discussing the upcoming earnings season. I wish I could tell you the guest’s name and what organization he was with, but I was on the exercise bike at the time and wasn’t able to write down the information. Please don’t take these figures as certain, but I believe he said that 26% of the S&P members have lowered guidance heading into this earnings season and that compared to only 13% lowering guidance heading into the last earnings season back in October. Again, don’t quote on those figures—I tried to find the interview and I tried to find the stats myself, but to no avail.

Big Banks See Short Interest Increases Ahead of Earnings

The banking sector gets the earnings season started next week with Bank of America (NYSE: BAC), Citigroup (NYSE: C), and Wells Fargo (NYSE: WFC) all reporting. Citi is expected to report on Tuesday while Bank of America and Wells are expected to report on Wednesday.

Looking at the short interest on these three stocks, all three saw big jumps in their short interest in the most recent report from December 14. Short interest on Wells Fargo jumped from 25.55 million shares to 35.53 million shares, an increase of 39%.

Citi saw short interest jump from 18.03 million shares to 20.66 million shares, an increase of 14.6% and Bank of America saw short interest increase from 136.1 million shares to 147.9 million shares for an increase of 8.7%.

The rise in bearish sentiment extended to ETFs as well with the Financial Select Sector SPDR (NYSE: XLF) seeing short interest jump from 62.4 million shares to 80.8 million shares—a 29.4% increase. All three of the banks I mentioned above are in the top five holdings in the ETF.

What all of this means is that pessimism is increasing toward the financial sector. Rising pessimism is a sign of lower expectations for what investors believe will happen after the earnings reports. As a contrarian, I normally like lower expectations as it increases the chances of an upside surprise. Unfortunately, I’m not sure that is the case this time.

The Industrial Sector Could Be a Problem

One sector that will see earnings reports start to roll in two weeks from now is the industrial sector. This sector could have a major problem as the trade war with China continues.

These companies will have to issue forward guidance based on the current economic environment and that could spell trouble. China’s Purchasing Managers Index (PMI) dropped to 49.4 in December and readings below 50 indicate a contraction in the industrial sector. Here in the U.S., the ISM report dropped from 59.3 to 54.1 from November to December, and that is the biggest one-month drop since the 2008 recession.

The fourth quarter results might still be able to meet expectations, but the guidance numbers are the most likely source of problems. If China’s industrial sector is in a contraction and the U.S. is slowing down along with Europe, the projected earnings and revenue numbers are likely to come up short of what investors think they should be.

It is often said that the market is a forward looking mechanism and that tends to be a true statement. Unfortunately, that applies to both good news and bad news. Back in 2000, the stock market turned lower well before the economy saw a dip in GDP. If the industrial stocks do offer lower guidance than investors are expecting, we could see the selling pressure resume sooner rather than later.

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