What happened
Wall Street analysts are forecasting profit growth of 23.3 percent for the second quarter across the S&P 500, the index of the 500 largest listed companies in the United States. Reporting season opens on 13 July, and the first big names out of the gate include PepsiCo and Delta Air Lines.
Ten of the eleven sectors in the index are forecast to post higher earnings per share than a year ago. Energy is expected to lead the pack, helped by the oil price spike earlier in the year, followed by information technology and materials. Health care is the only sector expected to report a decline.
Markets have already priced in a good deal of optimism. The S&P 500 gained 0.72 percent to close at 7,537.43 on 6 July, while the Dow Jones Industrial Average climbed 155.84 points to a record close of 53,055.91. In London the FTSE 100 has been flatter, ending 8 July marginally lower.
The early results have been mixed rather than triumphant. PepsiCo posted adjusted earnings of 2.20 dollars per share, a whisker below the 2.21 dollars analysts had penciled in. And AstraZeneca shares fell almost 8 percent after its heart disease drug Wainua failed to hit its target in a late-stage clinical trial.
Why it matters
Share prices are, in the long run, a claim on company profits. Everything else, from interest rate speculation to political noise, is a debate about how to value those profits. Earnings season is the four-week window each quarter when the guessing stops and companies publish the actual numbers.
This season carries more weight than most. With central banks holding rates high, investors cannot rely on cheap money to lift valuations. If share prices are going to rise from here, they have to be pulled up by profits doing the work. A forecast of 23.3 percent growth is the market saying it expects exactly that.
The risk is that the bar has been set very high. When expectations are modest, companies can clear them easily and shares rise. When expectations are heroic, even a solid result can disappoint. PepsiCo missing by a single cent is a small illustration of how unforgiving the mood can be.
The AstraZeneca fall shows the other side of the coin. A single failed drug trial wiped nearly a twelfth off the value of one of the largest companies on the London market, a reminder that index-level optimism does not protect any individual holding.
Explained simply
Earnings season is parents evening for the stock market. For three months the companies have been telling you how well they are doing. Now the actual report cards arrive, and the grades either match the story or they do not.
Here is how the mechanism works. Before a company reports, dozens of professional analysts publish estimates of what its profits will be. Those estimates get averaged into a consensus number. The share price already reflects that consensus, because everyone who wanted to buy on the expectation has already bought.
So when the results land, the share price does not move on whether profits went up. It moves on whether profits went up by more or less than the consensus expected. A company can grow profits 20 percent and see its shares fall, if the market had been expecting 25 percent.
Earnings per share, usually shortened to EPS, is simply total profit divided by the number of shares in issue. It is the standard scorecard because it tells you the profit attached to each individual share you own.
The second thing that moves prices is guidance, meaning what management says about the months ahead. A good quarter paired with a gloomy outlook usually sends shares down. Investors are always looking forward, never back.
What it means for you
If you have a workplace pension or a stocks and shares ISA holding a global tracker fund, roughly 60 to 70 percent of that money is invested in American shares, and a large slice of it in the handful of technology giants at the top of the S&P 500. The next three weeks will move your balance more than almost anything else this summer.
Resist the urge to trade around it. The single most reliable finding in investing research is that people who check their portfolios daily during earnings season tend to sell after falls and buy after rises, which is precisely backwards. If your money is invested for retirement in ten or twenty years, a bad Thursday for PepsiCo is noise.
If you hold individual shares, the AstraZeneca fall is the lesson. A single company can lose 8 percent in one session on news that has nothing to do with the wider economy. Holding a handful of names means accepting that kind of risk. A FTSE 100 tracker or a global index fund spreads it across hundreds of companies for an annual fee of around 0.1 percent.
If you are drawing an income from investments, note that energy is expected to lead profit growth this quarter. That tends to support the dividend payouts from the big oil companies, which make up a meaningful chunk of the income generated by UK equity income funds.
The bigger picture
The current rally has been running for a remarkably long time, and the S&P 500 has now delivered a positive July in each of the past eleven years. Streaks like that end eventually, and the combination of high rates and high expectations makes this a plausible moment.
What to watch is the gap between forecast and delivered growth. If companies come in comfortably ahead of the 23.3 percent estimate, the argument that profits justify current valuations gets stronger. If they fall short, the market is left holding record prices with nothing underneath them.
Key dates: PepsiCo and Delta on 13 July, then the large banks, then the technology giants in the final week of the month.
