Three Key Metrics to Track Ahead of the Earnings Onslaught

Submitted by Wall St. Daily as part of our contributors program.

On Monday, I debunked the age-old practice of treating aluminum giant, Alcoa’s (NYSE: AA), earnings as a leading indicator for the rest of corporate America.

It’s just not reliable.

A handful of pundits agree with me. Yet they go a step further and contend that JP Morgan Chase (NYSE: JPM) should assume Alcoa’s place of prominence. Try again!

While JP Morgan has a broader reach into our economy, it’s still just one company. And reading too much into a single company’s report is asking for trouble.

There’s just no way that doing so can accurately predict the outcome for thousands of other companies. Period.

Accordingly, I don’t recommend wasting any more time hunting for such a “Holy Grail” stock. Instead, we should focus on three key metrics that really matter this reporting season.

But before I get to them, let me provide a little context…

Expectations: From Bad to Worse… and Still Irrelevant

No doubt about it: This earnings reporting season, which kicks into high gear next week when 732 companies are scheduled to report, promises to be one of the ugliest in recent memory.

On a whole, S&P 500 companies are expected to report a 2.6% drop in profits. If actual results match that projection, it would end the growth streak we’ve seen the past 11 quarters in a row.

For months now, analysts and companies alike have been preparing us for this inevitability, as well. I wouldn’t read too much into the negativity, though.

As Dan Greenhaus, Chief Global Strategist at BTIG, says, “Earnings guidance is a game that everybody plays and nobody acknowledges.”

In other words, companies’ overly downbeat projections could be setting the stage for a classic relief rally, as actual results (surprise) come in ahead of expectations.

Even if corporate profits do fall this quarter, though, we need to put them into perspective.

After all, the S&P 500 is still on pace for its third-highest earnings-per-share payout in history of $25. The second-highest total came in the third quarter of 2011, which makes year-over-year comparisons for this quarter tough. We’d basically need to hit an all-time high in profitability, which just isn’t reasonable to expect.

So instead of obsessing about the year-over-year earnings growth rate, we should be focusing on these three metrics.

~ Key Statistic #1: Earnings “Beat Rate”

As long as companies are producing more and more profits, stock prices are likely to charge higher.

And to quickly gauge whether or not the stock market should head higher based on earnings, all we have to do is monitor the earnings “beat rate.” That is, the percentage of companies beating analysts’ expectations for profits.

The bar’s set low from last quarter, too. Only 58.7% of companies beat earnings expectations, which is the lowest reading since the bull market began, according to Bespoke Investment Group. So any reading above 60% should propel stock prices higher.

~ Key Statistic #2: Revenue “Beat Rate”

Companies are finding fewer places to cut costs to boost earnings. That means they’ll be forced to boost profitability the old fashioned way – by increasing sales.

Again, expectations are low heading into this quarter. Based on estimates from FactSet, third-quarter revenue is supposed to be flat. (At the beginning of the quarter, analysts originally expected sales to grow about 2%. Blame Europe for the reversal.)

Projections mean squat, though. What we want to track are the actual sales results. They represent the clearest sign that demand for goods and services is increasing – or at least hanging tight – in the face of the European slowdown.

Here, too, we don’t need to worry about reviewing every last company report. We just need to track the revenue “beat rate,” or the percentage of companies beating analysts’ expectations for sales.

Like the earnings beat rate, the revenue beat rate came in last quarter at the lowest level since the bull market began, at 48.4%. Any reading above the long-term average of 61.8% should prove to be another catalyst for higher stock prices.

~ Key Statistic #3: Guidance Spread

Since the stock market is a forward-looking beast, past results don’t matter as much as expectations for the future. And, obviously, the market could use a healthy dose of optimism right now.

The easy way to get a pulse on expectations for the future is to track the guidance spread. That is, the difference between the percentage of companies raising guidance and the percentage of companies lowering guidance.

Simply put, a positive spread indicates that more companies are optimistic about the future. And a negative spread indicates that more companies are pessimistic.

As a frame of reference, the guidance spread has been negative for the last four quarters. Before that, it was positive for nine quarters in a row.

The end result? Any positive reading this quarter will go a long way to push stock prices higher.

Bottom line: Even after a weaker-than-average second-quarter reporting season, stocks managed to rally 6.5%, as investors had already priced in the worst news. I’m convinced the same is going to happen in the third quarter. With the bar set so low – along with the tendency for stocks to rise in the fourth quarter of a presidential election year – the market’s poised to rally into the end of the year.