Will the Earnings Season Start a Market Correction?
Market volatility has fallen to remarkably low levels, however, that could soon change with the arrival of the earnings season. Over the past 10 years, the emergence of first-quarter earnings reports has generally corresponded with a rise in volatility.Alcoa (AA) is set to unofficially kick start the earnings season as it reports its Q2 earnings on 11th April. The stock market has staged a remarkable comeback since hitting the lows in February, but the same can’t be said for corporate profits, which are expected to drop over 8%.
While I was expecting a market correction by the end of March, the recent rally has sustained itself for an extraordinarily long period. However, I think a weak earnings season can kick start a market-wide correction soon and investors should be cautious heading into earnings. The rally is surprising given the falling fundamentals, and another year over year dip in earnings will mark the fourth successive quarter of falling S&P 500 earnings — the longest period since the end of the financial crisis.
Investors tend to blame the fall of crude oil prices for the earnings decline. However, cheaper crude is beneficial for the U.S. economy and despite that S&P 500 earnings excluding energy stocks are still expected to fall 3.3% year over year.
As expected, estimates have fallen far enough and the bar is set very low for the companies to beat it. However, that shouldn’t be considered as a bullish sign as eroding fundamentals driven by falling earnings can lead to a significant correction in the market.
What makes the earnings worse is that the estimates are based on results provided by firms that eliminate certain items such as restructuring charges or stock-based compensations. According to Heard on the Street, results under GAAP have fared much worse and are likely to continue deteriorating.
Honestly, I didn’t expect the February-rally to last so long. I was expecting a market correction in March, but that didn’t happen. While it’s impossible to foresee a correction or a crash every time, I think investors should stay cautious heading into earnings. The market rally despite eroding fundamentals can prove to be disastrous due to steeply falling earnings.
I still think investors should dedicate over 40% of their portfolio shorting companies that can fall even in the most bullish of markets so as to hedge against a market correction. You can read my previous articles for new short ideas.