The fourth quarter earnings season has arrived. Estimates for the quarter have come down 11 percent over the past 12 months. However, this downward adjustment is not enough to classify the current S&P 500 EPS estimate of $25.29 as an easy hurdle to surpass. It's only 14 cents off of the 25-year peak level for operating earnings.
The current estimate is also 5 pct points higher than the third quarter of 2012. This is in spite of the fact that last earnings season, almost 60 pct of the S&P 500 companies failed to live up to their initial sales expectations and 30 pct missed their bottom-line estimates.
It's also important to highlight that GDP growth is largely expected to taper off in the fourth quarter as Bloomberg's consensus forecast shows growth dropping to 1.5 percent in the fourth quarter from 3.1 percent in the third quarter of 2012.
"In a historical context, the 4Q12 expected sequential earnings growth still appears too robust. In all of the reporting seasons of 2012, EPS growth rate has come in at or below the 20-year average sequential growth rate in each quarter," RBC Capital Markets analyst Ronald Dottin wrote in a note to clients.
The 5 pct growth expectation for this earnings period is a clear departure from the trend that has been in place.
"Therefore, we would not be surprised if this earnings season were to end on a sourer note than it has started—with about 5 pct of the S&P 500 companies reporting, the run rate of earnings surprise stands at 400 bps," Dottin said.
Meanwhile, earnings misses are expected to provide limited downside pressure. If this quarter's profit forecasts come under more stress, the downside risks to missing EPS estimates are more limited in this quarter than in the last. On the other hand, the upside performance potential for surpassing earnings in this season is the highest among the four periods.
"The 4Q trend exists, in our opinion, because it typically is the base to which analysts make forward year projections," the analyst noted.
If the quarter comes in lower than expected, fundamental analysts are more inclined to chalk the weakness to being front-end loaded and boost future quarterly EPS growth estimates. If numbers come in better than consensus, then forward estimates typically get an upward linear adjustment. This reduces selling pressure for weak earnings results, and the continued discussion around the fiscal cliff is likely to compound its effect.
Companies that missed revenue expectations can point to the lack of customer demand on political uncertainty. Moreover, the ones that navigate toward a positive earnings result will appear to investors as more resilient to the economic and political landscape.
"However, investors are unlikely to give companies a perpetual pass for missing financial thresholds. Our work has found that the spread significantly begins to narrow by the second and third reporting seasons. The calendar of events may work in stocks' favor now, but it's likely to provide significant tailwinds as the year progresses," Dottin said.
The middle part of the year is when most expect clarity on corporate tax rates and spending cuts, and economic activity to re-accelerate. The current 2013 EPS estimate for the broader market already reflects these rosy assumptions in the back half. If they don't come to fruition, downward pressure on the back of earnings risk could pack an even harder punch than its typical seasonal pattern.
"At the sector level, our concern that technology could derail the earnings trajectory for the broader market is mounting. For starters, the top 10 earnings contribution stocks in the tech sector comprise about 14% of the overall S&P 500 earnings," Dottin noted.
The bottom-up consensus is currently looking at earnings growth of 20 percent in 2013. The tech sector derives its profits through healthy margins than sales growth. Tech also pays the lowest effective tax rate of all the major S&P sectors.
If the government puts the squeeze on tax loop holes, this would likely impact tech margins more than other sectors, cutting into their primary source of generating solid profit growth.
"If this does happen, it's likely to come at a time when investors least expect it. Therefore, we suggest paying particular attention to how tax reform will impact the tech sector. It could be the key to the future strength of the broader market's EPS growth," Dottin added.