A rally in European stocks has masked a gloomy second-quarter results season that has led analysts to cut earnings forecasts and could see share prices falter if anticipated central bank stimulus is not forthcoming. Fifty-one percent of European firms have missed expectations and earnings for the second quarter are down on average 11.2 percent year-on-year, according to Thomson Reuters Starmine data.
Share prices, however, have gained on average around 6.6-6.7 percent in the last 30 days regardless of whether the company beat or missed forecasts, the data shows, lifted by expectations that global central banks will provide more stimulus to boost flagging growth. This has rendered markets susceptible to a pull-back if earnings momentum - analysts' upgrades minus downgrades as a percentage of total estimates - fails to improve.
"You wait a few weeks, companies will get to work on bringing down their Q3 and Q4 expectations," Andrew Lapthorne, head of quantitative equity strategy at Societe Generale, said. "If you finish a reporting season with the market relatively robust and volatility down, that then leaves you open to a pull-back in the intervening period," he said.
Implied volatility on the bluechip EuroSTOXX 50 index is at one-month lows. Expectations for third-quarter earnings are already being lowered. Over the last 30 days analysts have revised forecasts down by between 2 and 9 percent for most sectors, and 16 percent for information technology. Only consumer discretionary firms, which include companies in the retail and travel sectors, have so far escaped cuts, according to Starmine. The clouds are gathering with revenues tending to beat forecasts across the board even as earnings disappoint, suggesting companies' margins are being squeezed despite significant cost-cutting.
The rise in share prices coupled with a fall in earnings has pushed up price-to-earnings (P/E) ratios, which are frequently used to value companies. The pan-European STOXX 600 index is trading at around 10.7 times its constituents' expected earnings for the next 12 months, a level last seen in March, a n d rising closer to its 10-year average of 11.8 times, Datastream data showed.
Cyclical sectors - those exposed to the fortunes of the broader economy - including energy, industrials and materials have gained the most in the past month despite experiencing more earnings misses than beats, setting up the potential for share prices to retrace recent gains. J.P. Morgan strategist Mislav Matejka said some companies' valuations were stretched and earnings upgrades would be needed to sustain recent stock price gains. However, this was uncertain given the broader economic slowdown.
"It is crucial that activity picks up in order for the current rally to have legs but, so far, evidence on the ground is mixed," he said. Among the few sectors beating forecasts were defensive stocks such as utilities, health care and consumer staples, proving they can still perform despite tough economic climate.
However, these companies' share prices appeared to already reflect earnings expectations before the reporting season as they enjoyed strong gains earlier this year. Healthcare and consumer staples underperformed the broader index over the last month and utilities retreated.
Large and mid-sized companies fared a little better than small ones, of which 59 percent missed expectations. In the short term, small firms' earnings look set to remain under pressure with analysts cutting forecast by around 13 percent for the third quarter. "In a tough environment the smaller companies are the marginal suppliers and they are the first ones to take a hit to volumes and prices. However, as things start to accelerate, they are small enough and nimble enough that they will see the best earnings recovery," Neil Shah, director at Edison Investment Research, said.
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