At face value, the preliminary outlook for third quarter earnings season is not encouraging. Predominantly due to severe earnings weakness in the energy (-65.9%) and materials (-19.0%) sectors, S&P 500 earnings are expected to decline by 5.1% versus third-quarter 2014, and the bad news is not isolated to just these two sectors.
Three of ten sectors are expected to grow third-quarter earnings by low single digits, consumer staples earnings are expected to decline by 2.3%, and technology is essentially flat (+0.2%). This leaves only the health care (+7.4%), telecommunication services (+9.6%), and consumer discretionary (+11.9%) sectors poised to report reasonably constructive news.
So if the third quarter earnings season is going to be such a downer, why has the stock market stabilized and even rebounded 8.0% from the interim lows set on Aug. 24 and 25? Global Markets Intelligence (GMI) Research believes that investors continue to look past recent negative developments, such as the strong U.S. dollar, weak commodity prices, and their cumulative drag on energy, material, and industrial sector corporate earnings in addition to the likely side effects of the Federal Reserve's eventual tightening of monetary policy.
We suspect that the relatively healthy prospects currently characterizing a single sector, consumer discretionary, summarizes why investors so far have refused to throw in the towel when it comes to their collective optimism for the equity market.
As a barometer of the U.S. economy's health and ability to generate respectable corporate profits, despite the headwinds previously cited, S&P 500 consumer discretionary earnings are expected to increase by 12.0% in the third quarter and then improve further to 15%-18% quarterly growth throughout 2016.
Illustrating investors' ongoing sense of optimism concerning the U.S. consumer, the sector's earnings growth is forecast to exceed that of the entire S&P 500 through year-end 2016, according to S&P Capital IQ consensus data (see chart below).
Prospective trends in U.S. retail sales will be a crucial economic variable determining the growth rate of consumer discretionary corporate earnings, and therefore the price performance of this crucial sector of the stock market, in the year ahead. Retail sales set an all-time post-financial crisis record of $378.9 billion in March 2011 -- and never looked back.
As of Oct. 14, retail sales set yet another all-time monthly record of $447.7 billion for September. Although the headline number may have disappointed relative to consensus expectations, equating to only a 2.4% growth rate year over year, retail sales were actually much healthier when excluding the influence of volatile retail gasoline prices.
Excluding the gasoline service station component, retail sales grew by a much healthier 4.9% in September. Ignoring the negative influence on personal consumption seen in January and February 2014 because of severe winter weather, U.S. retail sales--excluding gasoline--have now sustained growth rates in excess of 3% since September 2010.
Looking toward 2016, we believe that as long as retail sales continue their longstanding trend of setting record highs on nearly a monthly basis, the U.S. consumption-driven economy and consumer discretionary sector earnings will be just fine.
Current third-quarter aggregate earnings growth expectations of 12% for consumer discretionary constituent companies, if achieved, would signify a healthy update on the fundamental status of both the sector and the overall U.S. economy, in our view.
As the U.S. economy forges ahead, and so long as major emerging and developed trading partner countries avoid falling into a deep or prolonged recession, the intermediate-term path for high-quality equity prices still appears to be higher.