Olé! Brace for Earnings Season!

What a great match in Soccer City on Sunday and congratulations to Spain for this well earned victory and their first World Cup ever.

Now that the World Cup is over, traders will be focusing on earnings. David Milstead of the Globe & Mail reports, Wary markets brace for earnings season:

The second-quarter earnings season that kicks off today may be the make-or-break test for a global recovery that suddenly looks to be sputtering.

The past several weeks have seen a string of disappointing economic data, as growth in the U.S. and elsewhere unexpectedly slowed. More bears came out of hibernation to argue the recovery that was once seen as V-shaped would look more like a W – an imminent double-dip recession.

Last week’s market rally, in which the prior week’s carnage was reversed, occurred without any major economic or market news and blunted that talk.

What will occur over the next several weeks, however, is a string of major earnings releases with little margin of error, owing to a consistent ratcheting up of expectations in 2010.

“You’re going to need a lot of upside surprises to break the negative mentality,” said Beata Caranci, the deputy chief economist at TD Bank. And the high expectations “tells you where the balance of risks are – it’s much easier to disappoint than surprise.”

Peter Buchanan, a CIBC economist, said “as economists are getting more cautious, analysts for companies in the S&P 500 have not cut their estimates. We’ll see who’s right in the weeks to come.”

Robert Kavcic, an economist at BMO Nesbitt Burns, notes that at the beginning of 2010, the consensus analyst estimate for 2010 earnings for S&P 500 companies was 8.6 per cent below 2009 levels. On the strength of the fourth-quarter 2009 and first-quarter 2010 earnings reports, 2010 estimates have been jacked up so much that the consensus numbers are now 34 per cent above 2009.

For the second quarter, consensus estimates are for earnings to grow 27 per cent over 2009’s second quarter, according to Thomson Reuters.

“The last three quarters have been absolute blowouts with respect to earnings surprises,” Mr. Kavcic said, as about 80 per cent of S&P 500 companies have beaten consensus, versus a historical norm of about 66 per cent. “But the market can only be fooled for so long … it won’t be surprising if the impressive rate of earnings surprises seen in the past three quarters marks the high watermark of this cycle.”

Mr. Buchanan, at CIBC, notes that Canadian analysts have actually tempered expectations recently, meaning there’s more downside risk in the U.S. from missed numbers.

Investors will get samplings from several sectors this week. Alcoa Inc. kicks it off Monday with a look at industrial production.

Other companies reporting this week include Intel Corp., Advanced Micro Devices, Google Inc., JPMorgan Chase & Co., Bank of America Corp., Citigroup and General Electric.

“Cost-cutting is still the order of the day, so the earnings numbers probably won’t disappoint like the economic numbers did,” said TD’s Ms. Caranci.

Of course, cost-cutting typically includes head count, and that’s a big reason why the blowouts in corporate earnings haven’t translated to an across-the-board economic recovery.

“We should have employment [head count gains] at a rate four to five times higher than it is, based on the health of corporate profits,” Ms. Caranci said. Productivity is at its highest rate since the 1960s, unit labour costs are at their lowest point, and companies have very high liquidity, as measured by their ratio of current assets to current liabilities – yet companies haven’t brought back workers to any large degree.

“The longer that persists, [a downturn] is self-prophesizing,” Ms. Caranci said. Another quarter of healthy earnings, however, “might ignite some faith in the sustainability of this recovery, and that might feed into the labour market.”

To that end, the real news of the earnings season may not come in the second-quarter numbers themselves, but in the second-half outlooks issued by management. “They’re not necessarily going to be negative, but they may be somewhat cautious,” said Mr. Buchanan.

The S&P 500 is coming off its biggest weekly gain in over a year. Some analyst like James Barnes of GaveKal Dragonomics in Hong Kong, think last week's surge in stocks was due to a shift in asset allocation:

Bonds outperformed stocks in the second quarter of the year quite admirably, and when bonds beat stocks by 23%, as they did between April and June, it’s a rare and strong signal to pension funds and insurance companies that they need to jump into stocks, which Barnes reckons (citing anecdotal evidence) happened Wednesday.

With U.S. and European companies hanging on to more cash these days than usual, the takeover and buyout impulse is growing as a viable theme, Barnes argues, pushing up the share prices of potential takeover targets.

With so much cash on hand, David Templeton asks, Will Dividend Payments Likely Improve?:

As I have noted in past posts, 2009 was the worst year for dividends since the late 1950s. S&P reports that dividends on the S&P 500 Index fell 21%, which was the biggest decline since 1938. Even worse for investors was the fact that the higher quality dividend paying stocks lagged the broader market rebound in 2009 by returning 26% versus 65% for the S&P 500 Index. As Tom Huber, portfolio manager of T. Rowe Price's Dividend Growth Fund notes,

"A dividend-oriented strategy has to be looked at over market cycles—there are times when it will lag, typically coming off a market correction or recession, and times when it does relatively well, usually in periods of market turbulence."

Today, companies are in a position to once again focus on growing their dividends for several reasons.

* Strong Balance Sheets: Many companies are flush with cash. A recent Wall Street journal article noted, "U.S. companies are holding more cash in the bank than at any point on record, underscoring persistent worries about financial markets and about the sustainability of the economic recovery. The Federal Reserve reported Thursday that nonfinancial companies had socked away $1.84 trillion in cash and other liquid assets as of the end of March, up 26% from a year earlier and the largest-ever increase in records going back to 1952. Cash made up about 7% of all company assets, including factories and financial investments, the highest level since 1963."

* Sluggish Growth: In periods of slow economic and earnings growth dividends become a more critical part of the total return of a particular company's stock. In this environment companies are likely to respond to the investor's desire for more income from their equity investments. Since 1925, reinvested dividends have accounted for almost 44% of the total return of the S&P 500 Index.

* Less Volatility: Dividend paying stocks tend to be less volatile during downside market volatility. One factor we believe that will be present in the investment markets for the foreseeable future is a more volatile investing climate. A recent T. Rowe Price report notes, "dividend-paying stocks in the S&P 500 outperformed nondividend payers in every bear market since 1973 but tended to lag in bull markets, according to Ned Davis Research (NDR), a market research firm.

During the bear market from March 24, 2000, to October 9, 2002, the S&P 500 plummeted 49.1%, while the Dividend Aristocrats gained 15.5%, according to Strategas Research Partners, another market research firm. In the recent market decline from October 2007 to March 2009, the Aristocrats declined 49.6%, compared with 56.8% for the S&P 500."

* Long-Term Performance: "NDR calculates that from 1972 through March 31, companies in the S&P 500 that have consistently increased or started making their dividend payouts provided an annualized return of 9.4%, compared with 7.3% for companies that paid dividends but did not increase them and only 1.5% for non-dividend-paying stocks."

* Steady Cash Flow: "From 1980 through 2009, dividends on stocks in the S&P 500 grew at an annual compound rate of 4.7% compared with the 3.7% annual inflation rate."

Over a longer time period, principal growth of an equity portfolio outpaces that of a fixed income portfolio as well. The T. Rowe Price article cites a Ned Davis Research study showing this performance difference.

"NDR tracked the performance of two portfolios over the past 25 years. One consisted of the top 50% of dividend payers in the S&P 500. The other was the S&P Long-Term Government Bond Index. The study assumed all interest and dividend payments were taken in cash each year.

Assuming a $500,000 initial investment in each portfolio at the end of 1984, the equity index provided total dividend payments of more than $2.6 million through 2009, or about $212,000 more than the total interest payments from the bonds. Moreover, in terms of principal value, the original $500,000 investment in the stock portfolio grew to more than $2.8 million compared with about $908,000 in the bond portfolio."

For an investor then, a resumption of dividend growth could be at hand. The stock prices of dividend growers will likely benefit from this growth as well.

I wouldn't be surprised if high quality dividend paying stocks outperform in the next decade, but there are other sectors worth looking at as well. Last week Chinese solar shares popped after mega Chinese loans were announced:

News of China doubling the world's solar panels capacity by loaning Yingli Green Energy $5.3 billion in order to expand production had a positive impact on the stock. The funds will be lent by China Development Bank, which also funded approximately $12 billion to Suntech Power and Trina Solar in April.

"The loans are enough to increase the world's solar wafer and cell capacity by 100 percent," Jenny Chase, head of solar-energy analysis for New Energy Finance, told Bloomberg. According to the group, China accounted for 43% of world production last year.

And it's not just Chinese solars that rallied strongly last week. According to Bloomberg New Energy Finance, US solar stocks rebounded 6.9% with Power-One Inc, the US-based inverter and energy efficiency company, being the star performer.

But there are other sectors worth tracking too. For example, while everyone is worried about the collapsing Baltic Dry Index, China just posted a monster trade surplus with exports up a whopping 44%.

What does that mean for your portfolio? It means keep an eye on shipping companies which are heavily leveraged to the global economic recovery. Companies like Dryships (DRYS) are breaking out from important technical levels after being crushed.

And what about semiconductor companies like Lattice Semiconductor (LSCC) which surged 14% on Friday? It may also be breaking out and remains on my watch list.

Importantly, there is plenty of liquidity to drive risk assets higher, so don't be surprised if we have a low volume melt-up this summer. I think some sectors will do better than others this summer, but generally speaking earnings and companies' guidance shouldn't disappoint.

We shall see. Some experienced traders, like Tim Knight of Slope of Hope, believe this mini-rally fuel is going to run out soon, and he is positioning himself accordingly.

Who knows how this all plays out in the coming weeks. I believe there is way too much pessimism out there and that risk assets will be bid up. Instead of selling the news, traders and algos are likely to be buying the news. If underperformance anxiety kicks in, everyone will be chasing indexes higher again. Stay tuned, should be interesting to see how things unfold this earnings season.