What to Watch for This Earnings Season

Yes, we are getting close to that time again; the next earnings season is almost upon us. Many investors will be focusing on the level of earnings growth, not only for the past quarter, but also for the guidance issued by firms for the future.

The stock market is up significantly this year, so any disappointment in guidance regarding corporate earnings could cause a significant market correction.

A recent example of the type of market correction that’s possible is Hertz Global Holdings, Inc. (NYSE/HTZ). The company lowered its guidance for revenues and corporate earnings for the full year, which caused its shares to sell off significantly.

Whenever you have stocks pricing in extremely strong levels of corporate earnings, any marginal disappointment will lead to a market correction. In this instance, Hertz adjusted its corporate earnings range for the full year from $830–$875 million down to $780–$830 million. (Source: Hertz Global Holdings, Inc. web site, last accessed September 27, 2013.)

Chart courtesy of www.StockCharts.com

The company cited weaker-than-expected volume at U.S. airports. The stock did sell off significantly, which goes to show you how vulnerable stocks are to a market correction.

Having said that, we have to put things in perspective. Hertz will still report a record amount of corporate earnings for fiscal 2013, so this isn’t a case of a company losing money; it’s simply making less than what the market expects. Price is always relative, and stocks fluctuate between optimism and pessimism.

When people are too optimistic about corporate earnings growth, it drives valuations extremely high. This also leaves stocks vulnerable to a market correction if corporate earnings even marginally disappoint.

Looking at the forward price-to-earnings ratio, Hertz is still reasonably priced at less than nine-times its fiscal 2014 earnings per share. With the company expecting to generate earnings growth of 30% year-over-year (before taxes) for fiscal 2013, the company still fundamentally has upside potential. What I would look for is to determine at what price level investor sentiment will match up with this adjusted level of corporate earnings.

The reason I bring up Hertz is to show that even corporations generating strong corporate earnings are susceptible to a market correction. Expectations are pricing in very strong levels of corporate earnings, and any disappointment will see similar scenes played out across many other stocks.

The real question is: how will corporate earnings continue growing? We’ve seen firms cutting costs and buying back shares; both are positive for corporate earnings growth. But at some point, revenues need to begin increasing. If that doesn’t occur, we could certainly see a market correction, which will re-price the value of shares to adjust for lower levels of corporate earnings growth.

Going into this earnings season, I would be cautious of many companies that have exposure to consumers, as I see a lower level of discretionary spending. With wages stagnant and costs rising, including energy costs and interest rates, this squeeze will result in a lower level of marginal spending.

With the budget debate now hitting full force, this will further decrease the incentive for Americans to spend on discretionary items, including travel. With Hertz stating that it is seeing less business from U.S. airports, this is just further evidence that the average American is trying to cut back on discretionary spending—which isn’t good news for many companies’ corporate earnings. You may want to be on the lookout for a possible market correction ahead.

This article What to Watch for This Earnings Season was originally published at Investment Contrarians