SELL IN MAY? YOU MAY BE SORRY!

The Q1 earnings season is almost over as 91% of the S&P 500 companies have reported.

S&P says that 68% (Factset: 75%) beat the polar vortex impacted estimates, the best beat rate in over 2 years. Factset adds that

In aggregate, companies are reporting earnings that are 5.5% above expectations. This surprise percentage is above the 1-year (+3.1%) average, but slightly below the 4-year (+5.8%) average. If this is the final percentage for the quarter, it will mark the highest earnings surprise percentage since Q1 2011 (7.0%).

In terms of revenues, 54% of companies have reported actual sales above estimated sales and 46% have reported actual sales below estimated sales. The percentage of companies reporting sales above estimates is equal to the 1-year (54%) average, but below the 4-year average (58%).

Q1 EPS are now estimated at $27.41, a good 1% higher than last week’s estimate. Trailing 12-m EPS would thus total $108.94, continuing the upward trend begun in Q3’13. In effect, S&P 500 trailing earnings are up 9.7% since Q2’13.

Factset again:

At this point in time, 88 companies in the index have issued EPS guidance for the second quarter. Of these 88 companies, 62 have issued negative EPS guidance and 26 have issued positive EPS guidance. Thus, the percentage of companies issuing negative EPS guidance to date for the first quarter is 71%. This percentage is above the 5-year average of 65%.

But this percentage is significantly lower than what we have seen during the last 2 years. In fact, 26 companies have positively preannounced for Q2 so far. This is the highest absolute number of positive preannouncements since Q1’13 (24) which was reached after 106 companies had preannounced.

This is pretty significant: one, we know that companies are inherently wary of over-promising, knowing very well the cost of under-delivering. Two, Q2 estimates currently assume a breakout of corporate margins as this Factset chart illustrates. The fact that corporations are not trying to reign in these estimates is positive. Mean-reversion remains elusive…

Such a breakout in corporate margins could be significant for market psychology, potentially lifting expectations and confidence in the apparently fairly optimistic estimates for the rest of 2014. In fact, while forward estimates normally are being ratcheted down at this time of the year, estimates are actually inching up for 2014 as a whole.

This may well have to do with the increasing signs that the U.S. economy is in a more solid expansion mode. ISI’s Company Surveys advanced from 54.4 to 54.7 last week, the highest since July 2006, led by retailers and homebuilders, with trucking also helping.  Breadth also improved as the Company Survey Diffusion Index, which leads the regular surveys, was unchanged at +9.4%, the highest since March 2011. It may be the weather bounce, but a broad bounce it is.

S&P calculates that trailing 12-m operating earnings could reach nearly $120 at the end of 2014, 10% above current levels. At 1880, the S&P 500 Index would thus be trading at 15.7x 2014 EPS, a level many would consider reasonable (even though the long-term median is 13.7x).

If fears about the economy, profits and margins fade away, sell in May, and you may be sorry.

This market is not terribly attractive being only 6% below the Rule of 20 fair value level of 1994 amid many problematic external factors (see U.S. EQUITIES: BETTER INTERNALS, SCARY EXTERNALS).

But I must acknowledge that profits, the most dependable underpinning for equities (vs P/Es), are pretty strong and look set to climb 10% during the next 9-12 months. Importantly, RBC Capital calculates that, ex-Financials, domestically oriented companies are recording earnings up 9.3% Y/Y in Q1 compared with +2.2% for globally oriented companies. This reduces the earnings risk linked to potential turmoil in Europe. Furthermore, RBC notes that

Financials and Energy were a drag on 1Q results. Specifically, the big-5 banks saw a 20.6% drop in earnings due to weak capital markets activity and BAC legal expenses. Within Energy, a 44% drop in crack spreads pressured margins in non-commodity sensitive names, resulting in a 14.4% decline in earnings. The setup for 2Q appears to be strong. Current forecasts point to an acceleration in Y/Y nominal GDP growth. Further, the big-5 banks and Integrateds and Refiners will
benefit from a healthier operating environment.

While the inflation risk remains, it is dwarfed by the potential gain in trailing EPS in 2014. Sell in May, you may be sorry!