Investing For Beginners: A Guide to the Stock Market and the Earnings Season

Since early May, when US markets suffered a jolt to their confidence, pessimism has dominated market sentiment in the short term.

Technicals have confirmed the prevailing market sentiment, with the DOW, S&P500 and NASDAQ all locked in weekly down trends.

However, since last week the Dow Jones has rallied over 750 points from the lows of last week. So, what’s caused the turnaround and is it sustainable? Has market sentiment changed in the medium term?

What’s caused the recent share market turn around?

Previously we looked at how markets reacted to the release of economic news. Financial markets are forward looking beasts. The release of economic data rarely changes the sentiment of market participants.

However, changes to the economic outlook will impact directly on future company earnings. How those economic changes impact on company profits is the primary factor that influences market sentiment.

It is the anticipated improvement in future company earnings that is driving the current turnaround in the US markets. Market participants are becoming increasingly optimistic earnings will continue to improve.

Earnings Reports – The Basics

The earnings season in the US, occurs in the month following the end of each quarter: January, April, July or October.

Changes in the US markets are often reflected on European and Asia exchanges and as such, the US earnings season is generally viewed as a ‘bell-weather’ for world markets.

Prior to an earnings period, analysts will provide guidance on how they expect a company to perform. Analysts use forecasting models and company issued guidance (on forecast profits or losses) to derive an estimate of a company’s earnings.

However, caution is always needed when it comes to analyst forecasts because they can be notoriously off-the-mark. Analysts typically adjust their forecast earnings up or down in the weeks and days prior to the start of the reporting period.

When a company releases its earnings, the earnings statement is typically reported as either:

1. Above analysts’ expectations (i.e. the company’s earnings report is stronger than expected);
2. Below analysts’ expectations (i.e. the company’s earnings report is weaker than expected);
3. In line with analysts’ expectations (i.e. the company’s earnings report is as expected).

Company earnings reports are closely watched by all market participants. Unexpected positive earnings will result in a boost to a company’s share price whilst unexpected negative earnings will see the share price of a company decline, often quite rapidly.

What are the market expectations for the reporting season?

Recently analyst projections for the second quarter earnings have been revised down as market expectations become more cautious.

In 2009 companies earnings were heavily influenced by companies being forced to cut expenses rather than increasing revenues.

This season’s earnings will be released against a back drop of conflicting economic signals in the US and other parts of the world (including Europe and China).

Analysts are hoping that company earnings growth is built on increases in production and consumption rather than inventory rebuilds and cost cutting.

In addition, analysts and economists will be scanning the language contained in company guidance reports for clues on the US economy and whether a ‘double-dip’ recession remains a real possibility.

The current change in market fortunes is occurring because analysts, traders and share market investors are growing hopeful that a strong earnings season will be enough to propel the market out of its current slump.

What you should be looking for in the earnings reports

Astute traders and investors will be looking closely at the earnings and guidance statements and asking themselves the following:

1. How upbeat is the company’s management for the coming year?
2. Do they expect earnings growth to continue?
3. Will companies be hiring more employees?
4. What will companies do with their cash reserves?
5. Do they intend to invest more or retain their cash reserves?
6. What impact will exchanges rate movements have on company earnings?
7. What impact will commodity prices have on company earnings?
8. What are management expectations for consumer confidence and spending?

These questions are typical of all reporting seasons. However, as this reporting period unfolds, you should also be considering the following:

1. With US congress soon to reconvene, how is this likely to affect the market?
2. What impact will the European bank stress tests have on world markets?
3. How will European austerity measures affect world markets?

Those looking for share market tips on where the market is likely to head in the coming months will need to seek out the answers to these questions and be alert to any improvement or deterioration in market sentiment.

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