Investors Should Focus More on Earnings, Less on Economic Data, in Second Quarter

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David Evanson and Oliver Pursche

TheStreet.com, Spring, 2015

Remember that catchy tune by Mili Vanili, “Blame it on the Rain” from 1989? That band turned out to be a fraud and so is “rain” or other weather events as an excuse for bad earnings, poor growth or whatever statistic economists or CEOs missed on (the March employment report certainly comes to mind). Blaming the weather has become the go-to excuse for under-performance, the modern-day market equivalent of “the dog ate my homework.”

Market participants should focus earnings — which will be critical for bulls looking to regain their footing. First quarter earnings season kicks off on Wednesday afternoon when Alcoa (AA) reports. Over the past few weeks, analysts have significantly lowered their expectations for corporate earnings, as economic activity has slowed significantly in the first quarter. The combination of the port strike in the West, sharply lower oil prices impacting the heartland (shutting down oil and gas projects, energy sector layoffs, etc.), and a stronger dollar eroding earnings from abroad are all legitimate reasons for the slower than forecast growth.

However, there are also real structural issues that are becoming clearer that are causing sub-par growth. For instance, while wages have grown, personal consumption, that is, spending, has fallen slightly.

Also, manufacturing activity has been declining, while inventories have started to flatten out. In other words, while seasonality and circumstance beyond our control have certainly impacted the economy, there are also fundamental reasons that are plaguing us.

The upcoming earnings season will be the most critical component to the markets direction over the coming months. As the chart below indicates, corporate earnings have made their most significant upward move in the first quarter of each of the last three years.

In spite of negative GDP growth for the first quarter of 2014, corporate earnings rose by a solid 6% — largely justifying todayzzs stock market levels. In other words, while not cheap, U.S. stocks are not particularly overvalued at current levels. However, a flat first quarter earnings season could mean real trouble for bulls.

Markets, in particular the stock market, are forward-looking mechanisms, pricing assets on expectations more than on reality. So far, investors have expected the United States economy and U.S. stocks to be the best option among a batch of bad ones. That might change. Slower than expected growth in the U.S. juxtaposed with improving conditions in Europe may shift the balance for investors.

The strong dollar has masked the recent strong performance by European markets, nearly wiping out all of the gains. However, on a currency hedge basis, European markets have shined. Take, for instance, the Deutsche Germany Hedged ETF (DBGR), up an impressive 15% year-to-date. And the Wisdom Tree Euro Hedge Equity ETF (HEDJ) is up more than 20% over the past 12 months.

Expect the dollar to stabilize and have less of an impact, meaning that hedging out the currency will not be as critical, but still has many benefits — after all, itzzs one less thing that can go wrong. As first quarter earnings season gets rolling, smart U.S. investors should be vigilant and consider looking overseas for some more attractive values.

As everyone knows, the European Central Bank has just embarked on its version of quantitative easing, meaning that asset prices in Europe will have the wind at their back for a while. Conversely, the U.S. Fed is contemplating the timing and mechanisms by which to begin to unwind some of its QE and easy monetary measures. Donzzt abandon U.S. stocks, but donzzt miss out on growing opportunities beyond our borders.

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.

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