If you haven’t heard by now, S&P 500 (NYSE:SPY) earnings estimates for the 2nd quarter have dropped 45% in the past 2 weeks. How is that possible? How could analysts have been that wrong? It almost sounds like a set up to allow companies to beat the street.
Before you freak out over a growth rate estimate that Factset Senior Earnings Analyst John Butters says has dropped from 14.2% to 7.9%, you can narrow your witch hunt to just one sector, and even to a single stock: Bank of America (BAC).
That’s right. All by itself, the Charlotte-based lender’s decision to settle a lawsuit over mortgage backed securities has caused numerous ripple effects, that analysts say only something like an unexpected $9 billion loss can do.
Aside from the hit to the expected growth rate of the total S&P 500 index (NYSE:SPY), the BofA bombshell had an even more pronounced impact on the Financial sector. According to Factset, the Q2 growth rate estimate plunged from +18.6% to -18.4% faster than you can say press release.
And Butters says, these types of distortions can be very confusing and misleading.
For example, why not just record it as “ex-items” or a “one-time event” like so many other companies do?
Butters says “in the case of many one-time items, analysts say it’s just a one-time thing, not part of normal operations, so therefore we’ll exclude that number. In this particular case, the analysts believe those charges had been part of the normal operations of Bank of America so therefore the majority of analysts elected to include them.”
And what about sector players? The Financial Sector SPDR ETF (XLF) is among the most actively traded and widely held issues of its kind.
On this matter, Butters says the headline loss expectation on the sector level actually masks the fact that “5 of 7 industries in the sector are expecting growth” including Commercial Banks, Consumer Finance, and REITs all pegged to deliver solid double-digit earnings growth.” He points to Discover Financial (DFS) which already reported and easily beat estimates by about 50%.
That said, Butters points to another issue plaguing the Financial sector (NYSE:XLF): Slack sales.
“It’s important to keep in mind that we’re still not seeing revenue growth in this sector… A lot are really benefiting from things such as lower credit losses versus a year ago and other items below the top line which help earnings growth. But we’re still not seeing topline growth in Financials,” he says. Officially, Factset estimates show Financials revenue growth expectations at just 0.5%, the lowest of the 10 sectors.
And finally, there’s the issue of PEs. If you vaporize billions in expected profits, that has to also do a job on the price-to-earnings ratio? The Boston-based analyst says “when you look at the S&P 500, right now it is trading at 12.7x forward earnings versus the long-term average which is about 15x forward earnings.”
He says for the past year, there has been a ”disconnect” where the forward PE has been below the 10-year average, explaining that “part of the reason is because expectations continue to increase” with analysts calling for increases in both Q3 and Q4 earnings.
“If we’re going to get back to this 15 PE ratio at some point 1 of 2 things will need to happen” he says, “either estimates will need to come down or the price of the market will need to come up, or some combination of the two.”
Even though Bank of America (NYSE:BAC) pre-announced their huge charge in late June, they are scheduled to officially report Q2 results next Tuesday. Factset estimates currently predict a quartlerly loss of $0.86 per share.
So now you know what to expect, what to look for and what to look out for.
You are free to walk about the cabin again.
Breakout is a YahooFinance production.