(HUM) A Look At Earnings, the Economy and the Federal Reserve

Notwithstanding the sell-off today, the market has been holding up quite nicely despite the overwhelmingly negative tone of recent economic reports. Of course the earnings season has not been that bad, and many see weak economic reports as the ticket to another round of quantitative easing from the Fed.

As many of you know, I am not very optimistic in my near-term outlook as I continue to see the horizon as quite cloudy. The market may get a temporary lift from QE hopes, but the effectiveness of more monetary easing is far from a given. The issues facing the economy are fiscal in nature, and addressing them requires a level of bipartisanship that is hard to come by in an election year. The picture is even grimmer beyond U.S. shores. It’s not just Europe; China and the other major emerging markets that drove global growth for the past many years are also struggling.

I don’t envision stocks holding their ground in the face of these challenges, particularly over the next 6 to 9 months. My outlook beyond that timeframe is quite positive as I expect meaningful visibility emerging over these issues. It is not certain that the clouds will lift entirely by then, but the odds are quite high.

The Economy & the Fed

We will get the first read on the U.S. economy’s second-quarter growth performance through Friday’s GDP report. But we already know that the economy has been losing momentum since the Spring months. The expectation is for GDP growth around 1.3%, which will be a sharp deceleration from the first quarter’s 1.9% pace and fourth quarter’s 3% rate.

We went through similar-looking slowdowns around the same time in preceding years as well. But unlike what happened last year and the year before, the exact triggers for the current slowdown are difficult to define. But there are enough uncertainties on the horizon, both domestic as well as international, that can justifiably be seen as has having a negative bearing on the business decisions at the margin.

Take for example the Fiscal Cliff situation. We still have about six months to go before tax hikes and spending cuts take effect. But this uncertainty is most likely having some negative impact on business and consumer confidence at present. Add to these domestic issues the questions about Europe and the growth outlook for China, and the deceleration in the economy’s growth momentum starts making sense. And none of these things are expected to get any better over the coming months, with or without more support from the Fed.

There is little evidence to prove that more Fed QE will do anything to economic output, particularly given where interest rates are already. Given the global economic slowdown and the fiscal policy nature of the hurdles facing the economy later this year (fiscal cliff, etc.), one could easily argue that more QE may juice up the market temporarily, but will be irrelevant to jobs and the economy. That realization will eventually sink as well.

There are no doubt a few bright spots – the housing market is showing signs of life and the drop in oil prices has been a real benefit, though partly offset by drought-induced upturn in food prices. The consensus view of the economy is that the second quarter GDP growth turns out to be the low point, with growth getting back to the 2%-plus vicinity from the third quarter onwards. It is possible that this outlook will come through, but I assign equal, if not more, probability to these growth expectations declining as we move forward.

How Good is the Earnings Season?

The second quarter earnings season currently underway has belied pre-season fears of sharp deterioration in the earnings picture. By most measures, the second quarter earnings season may not be that different from what we saw in the preceding two quarters.

We can discern a couple of trends from the roughly 25% of the companies that have already reported results. Companies are finding it difficult to achieve top-line gains in the face of the synchronized global slowdown. The strength of the U.S. dollar relative to other major currencies, primarily a function of the flight-to-safety trade, is proving as another headwind for companies. We are seeing these two elements at play across the board in different industries.

Bottom line, with margins already topped out and revenue gains difficult to come by, it is hard to get excited about what we have seen thus far. The only thing good about the earnings season is that it could have been much worse, which is perhaps getting perceived as a positive. We should keep in mind that earnings estimates have been steadily coming down for quite some time, though we haven’t seen as much downward revisions to next year’s estimates as we have for this year.

My sense is that we will start seeing those estimates come down as we move further into the second half of the year. Current expectations are for total earnings for the S&P 500 companies to increase more than 12% in 2013 to north of $114 ‘per share’. Given the unresolved global growth questions all around us, these earnings growth expectations seem on the optimistic side.

Putting It All Together

I didn’t say anything about Europe today, but that doesn’t mean it’s not a problem; it very much is. The region will remain a drag on global growth for a long time to come even when it resolves its existential issues. The problems facing the rest of the world, particularly the U.S. and China, pale in comparison to what Europe is going through. Downside risks no doubt remain for these two key economies, but the odds are high that visibility will improve beyond the next 6 to 9 months. The way to go is not to shun stocks altogether, but to lower your risk exposure by staying domestic through high quality stocks using the Zacks Rank as a key filter in your stock selection system.

Focus List Update

We made four changes to the Focus List this week – adding and deleting two stocks each. Exiting the portfolio are Humana (HUM) and Deere (DE) and they get replaced by Sketchers (SKX) and Western Refining (WNR).

Sketchers has been battling a number of issues in recent quarters, but the footwear maker appears to have turned the corner. The company’s second quarter results will likely remain challenging, but they seem well positioned for the upcoming back-to-school season. We are seeing some evidence of that in the positive trend in the company’s estimates, which have steadily been improving lately.

Western Refining is an independent refiner who after paying down its debt is now getting ready to distribute cash to shareholders. The company recently reinstated a quarterly dividend and also announced a meaningful buyback program to offset dilution from a potential convertible note maturity. Given the improved refining margin outlook, the company is well positioned to generate substantial free cash flows going forward, which it will likely deploy towards shareholder-friendly initiatives.

Both of this week’s deletions follow Zacks Rank downgrades, which we strictly follow as part of the Focus List design. We are, however, retaining MarkWest Energy Partners (MWE) in the Focus List despite its Zacks #4 Rank given the peculiarities of the master limited partnership (MLP) space. The primary driver of the Zacks Rank is trends in earnings estimate revisions, but earnings are not as material a metric for these MLPs as the outlook for distributable cash flows. And on that count, MarkWest remains well positioned.

I have long been a fan of MLPs given their low-risk, U.S. centric energy infrastructure related business models that produce stable recurring cash flows, pay out steadily growing streams of distributions (or dividends), and lack of correlation with the broader equity markets. In addition to MarkWest, we have Enterprise Products Partners (EPD), Plains All American (PAA) and ONEOK Partners (OKS) as Focus List members, and they have all been strong performers.

Zacks Investment Research

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