Dear Member,

Analysts project profits for S&P 500 companies to rise 10%, according to the consensus estimate compiled by Thomson Reuters. Given analysts’ propensity to under-estimate and corporations’ tendency to over-deliver, actual earnings could turn out to be better than forecast.

This trend has already started according to Dirk van Dijk at Zacks. My former colleague calculates that positive profit surprises are outnumbering negative ones by a ratio of better than 3:1. Only a small fraction of all S&P 500 members have reported, however, so the ratio will change.

Shareholders of individual companies want good news at the micro level, in addition to the macro level, and this where things could get a bit more troublesome. Thomson Reuters says the ratio of negative-to-positive earnings preannouncements is 2.6. The ratio was 1.8 for the first quarter of 2011 and 1.2 for the second quarter of 2010. In other words, a higher proportion of large-cap companies warned that profits won’t be as good as originally thought for the most recently completed quarter compared to last quarter and the same quarter one year ago.

Executives will have a long list of excuses to point to should their companies’ profits not be as good as shareholders had hoped. Among the excuses will be disruptions caused by disaster in Japan, bad weather in the United States, higher commodity prices and the economy. For some companies these will be legitimate reasons as to why profits were disappointing; for others, it will be a way of covering up poor execution.

It is not often clear where the influence of external factors ends (e.g., slowing economic growth, higher commodity prices, etc.) and where failure by management begins. A look at competitors’ earnings reports and financial statements can give some insight, however. You will want to compare changes in revenues and earnings growth rates as well as changes in profit margins.

External factors should impact revenues and profits for several related companies. If the company you are invested in disappoints and its peers had a good quarter, the problem could be with company itself—regardless of what the executives would like you to believe.

When evaluating earnings, you should also consider the reason you bought a stock. If you bought a stock for its growth characteristics and the rate of growth is showing signs of slowing, that would be a cause for concern. (This would particularly be the case if it looks like internal factors had an adverse affect.) Conversely, if you bought a stock because the valuation was cheap, a merely decent (as opposed to a great) report might be acceptable. In either case, be wary if profits are falling and are at risk of falling again next quarter.

What factors do you think will help or hurt second-quarter earnings? Tell us on the AAII.com Discussion Boards.

Stocks, Earnings and Washington, D.C.

July has historically been an okay month for stocks. Presuming that most companies do top expectations, it would seem that the markets should react positively. Plus many stocks went on sale last month, though the late-June rally removed a good part of the comparative discounts.

The big elephant in the room, however, is the debt ceiling. I cannot predict when our elected officials will reach an agreement, though it does seem that some progress has recently been made. The danger of selling stocks now with the intention of getting back in after an agreement has been reached is that you could miss out on any gains that do occur between now and then. Yes, you might also avoid any downside volatility, but it will take a better crystal ball than mine to predict how the markets will react between now and the August 2 deadline for raising the debt ceiling.

Looking for Earnings Momentum

One method of measuring growth is to compare earnings on a sequential quarterly basis. In simpler terms, are second-quarter earnings higher or lower than first-quarter earnings? If second-quarter earnings are higher, were first-quarter profits better than those of the fourth quarter? This is a restrictive way of looking at earnings, since it penalizes companies with earnings that fluctuate depending on the time of the year (e.g., retailers), but it is one way of looking for growth.

Kevin Matras, author of “Finding #1 Stocks: Screening, Backtesting and Time-Proven Strategies,” uses this approach for his Increasing Earnings screen. This strategy seeks out companies that have grown profits for six consecutive quarters. You can learn more about the strategy and see the list of stocks that pass it in the July AAII Journal.

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The Week Ahead

Second-quarter earnings season will officially start on Monday afternoon, when Alcoa (AA) reports. Joining the aluminum company will be fellow Dow component JPMorgan Chase (JPM), which reports on Thursday. A total of 10 S&P 500 member companies are currently scheduled to release quarterly results, including Citigroup (C) on Friday.

The week’s first economic reports will be the May international trade report and the minutes from the June Federal Open Market Committee meeting on Tuesday. Wednesday will feature June import and export prices. The June Producer Price Index (PPI), June retail sales, and May business inventories will be released on Thursday. Friday will feature the June Consumer Price Index (CPI), June industrial production and capacity utilization, the preliminary July University of Michigan consumer sentiment survey and the July Empire State Index.

Fed Chairman Ben Bernanke will testify before a House of Representatives committee on Wednesday.

The Treasury Department will auction $32 billion of three-year notes on Tuesday, $21 billion of 10-year notes on Wednesday and $13 billion of 30-year notes on Thursday.

AAII Sentiment Survey

Bullish sentiment, expectations that stock prices will rise over the next six months, increased 3.5 percentage points to 41.8% in the latest AAII Sentiment Survey. This is first the time that optimism has been above its historical average of 39% since April 14, 2011.

Neutral sentiment, expectations that stock prices will stay essentially flat over the next six months, rose 2.1 percentage points to 33.5%. This is a five-week high for neutral sentiment. The historical average is 31%.

Bearish sentiment, expectations that stock prices will fall over the next six months, dropped 5.5 percentage points to 24.7%. This is the lowest level of pessimism since January 13, 2011. It is also the just the second time in 20 weeks that bearish sentiment has been below its historical average of 30%.

Bearish sentiment has plunged by a cumulative 23.0 percentage points since setting a 2011 high of 47.7% on June 9. Bullish sentiment has improved 17.4 percentage points over the same period. A combination of factors has led to this shift, including rebounding stock prices and falling gasoline prices. Optimism is close to its historical average, however, and many investors still have concerns about the pace of economic growth and the ongoing debate over the debt ceiling.

This week’s special question asked AAII members if they will be more focused on the ongoing debate over the U.S. debt ceiling or on quarterly profits and earnings guidance. The overwhelming majority of respondents said they will be more focused on earnings. A sizeable minority said they would be more focused on the debt ceiling, however. A few respondents said they were either paying equal attention to both or were more focused on other market factors, such as the trend in stock prices.

Here is a sampling of the responses:

• “I’m focused on the debt ceiling debate, because a U.S. default will cause major problems for the stock market.”
• “Earnings reports will influence my decisions. The debt ceiling debate will (I predict) soon be settled one way or the other.”
• “Earnings until the decision is made to default; then all bets are off!”
• “If the elected officials can’t reach agreement on the U.S. debt, I fear many bad things will happen to the U.S. economy.”
• “The absolute value of earnings will be determined by the U.S. dollar. I’m a concerned as to what happens with the United States’ credit rating and interest rates.”

Are you bullish, bearish or neutral? Take the AAII Sentiment Survey and tell us.

AAII Asset Allocation Survey

Stock allocations fell to a nine-month low last month, according to the June AAII Asset Allocation Survey. Individual investors held 59.5% of their portfolio dollars in stocks and stock funds, a 1.5 percentage point drop. This was the first time since September 2010 that equity allocations were below their historical average of 60%.

Bond allocations declined as well. AAII members reported that bonds and bond funds accounted for 19.0% of their portfolios, a 2.1 percentage point decrease from May. Even with the decline, June was the 25th consecutive month that fixed-income allocations were above their historical average of 15%.

Individual investors did increase their cash positions, however. AAII members reported allocating 21.5% of their portfolios to cash, the largest amount since August 2010. The historical average is 25%.

The decline in equity allocations occurred as investors were pessimistic about the six-month outlook for stock prices. Bearish sentiment hit 47.7% on June 9 in our weekly Sentiment Survey, the highest level of pessimism since August 26, 2010. Many individual investors have also expressed angst over the lack of agreement on the debt ceiling, and it is likely that this contributed to the decline in bond allocations. At the same time, individual investors continue to be concerned about the potential for higher interest rates (and thereby lower bond prices) in the future.

This month’s special question asked AAII members which regions or countries they would invest in if they were given new money to buy stocks. The most popular choices were, in order, China, North America, Central and South America, and Asia/Pacific Rim. Many AAII members listed Brazil, Canada, India and the U.S. as specific countries they would invest new dollars in.

Take the survey http://www.aaii.com/assetallocationsurvey

Wishing you prosperity,

Charles Rotblut, CFA
AAII Journal Editor

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