Another earnings season is around the bend and its shaping up to be another good one.   As weve repeatedly mentioned over the last 6 quarters the environment is and remains particularly ripe for profit outperformance.  The trends that have been in place for the last 6 quarters remains largely intact.  Analysts remain woefully behind in terms of raising their estimates (see here) and corporate profits remain a margin story.

Figure 1 shows the corporate profit margin over the last 40 years.   Most important in the last few years is the turnaround in margins since Q4 2008 when enormous cost cutting campaigns kicked in.   The one remarkably positive sign during this recession has been the ability of corporations to remain lean and mean.  They have done a superb job in cutting costs and maintaining a fairly robust bottom line.  As you can see, profit margins are surging in recent quarters and should continue to trend higher as unit labour costs remain low (see figure 2) and revenues begin a slow rebound (the extent of this revenue rebound will be the key driver of any future market performance).  This trend has continued this quarter and should help power another quarter of better than expected earnings.

Perhaps most important in all of this, however, is expectations.  As we mentioned earlier, analysts have been woefully behind the earnings recovery.  This is best reflected in our expectations ratio which had been trending higher since just before the market bottomed last year and only recently began to roll over.  This shows that analysts estimates are becoming increasingly in-line with actual earnings and could create an environment that is not quite so friendly to the usual beat and raise environment we have all become accustomed to.  If a strong revenue rebound fails to materialise in the back half of the year analysts estimates will prove too high and stocks will respond negatively.

Currently, the market appears to be front-running the current earnings season and is pricing in another very strong earnings season.  Dont be shocked to see another quarter of very high percentage earnings beats and tepid revenue performance.  Whether that is enough for an already optimistic market remains to be seen.  My guess is we will see another sell the news earnings season.  Companies are running out of tricks to pull from the cost cutting bag and revenues havent quite stabilised to the extent that would make most executives highly confident in their full year earnings.  If we dont start seeing a pick-up in top-line growth this market is not going to be celebrating for long and the recent optimism in stocks will be proven wrong.