THE EXPECTATION RATIO CONTINUES TO FORECAST STRONG EARNINGS
Q3 earnings are officially over and it was one for the record books. 75% of all firms beat earnings estimates while just 14% missed. Companies didn’t just beat earnings – they beat earnings by a wide margin. The average historical beat is just over 3% while firms beat by over 7% in Q3. This is a continuation of a trend we have been talking about ever since the Expectation Ratio reversed course earlier this year.
The analysts have been fantastically wrong about the earnings outlook and that trend looks like it is likely to continue. The latest reading on the ER shows another strong reading of 1.27, but a short-term downtrend. This is a clear sign that we have likely seen a peak in the divergence between analysts and reality. In other words, the analysts are catching up to reality. For now, however, the long-term trend remains positive and the ratio continues to forecast an environment of very low expectations and stronger than expected earnings.
Curiously, the real underlying organic growth in earnings has not been all that strong. Firms continue to beat on very strong margin expansion that is primarily based on cost cutting. Just 29% of all S%P firms reported year over year revenue improvement last quarter. Of course, Wall Street isn’t a world based in reality, but a world based on reality compared to expectations. Despite this organic weakness, expectations remain very depressed and as long as firms can overcome these low expectations the market is likely to remain buoyant.
Cullen Roche
Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.
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12 Comments
How far back does the ER go ?
Would be interesting to see it back a few years to see if it would have gotten you out of the market.
It is why I turned cautious in mid-2007. The ratio began turning negative at that time. You can see a 3 year chart here:
http://pragcap.com/early-earnings-analysis
TPC,
Please excuse me for asking what might appear to be the obvious. How exactly should I read your ER chart? Which numbers are considered negative or positive/ bullish/bearish?
I know it’s not entirely clear. This is how I view it:
The trend is very important, but readings above or below one are most important. Any reading above 1 shows a positive change in the ratio meaning that analysts are still behind the curve. Vice versa for a reading below 1. The trends in the ER, however, tend to be multi month or quarter moves so it’s important not to ignore the trend. For now, the figures remain robust, but analysts could easily begin to overshoot (get too bullish) in the coming quarters as the trend is showing a very quick change in analyst sentiment.
The ER has been telling me not to short this market all year and it has been correct. It would have been nice if I’d had a bit more conviction in the indicator early this year (and been fully investor all year), but I think the extreme nature of this market and downturn made risk management and prudence the right call at the time. Hindsight is always 20/20 though, huh?
Thanks for the clarification. Hindsight is like having a crystal ball, nobody has one. I wish I too was fully invested and stayed invested all year.
The trend on the ER is now descending but still above 1, which like you said would mean analysts are still lagging in their estimates tho not by as much. But since the trend is down, would it portend a market that will rise higher in much smaller percentages? I suppose even by common sense the market will not be rising another 50-70% from here. 10-15% more on S&P is possible at least. I like your ER. Take that with Russell’s PTI and we should do ok.
How much do you think the easy comparison to the depressed earnings of Q4 2008 versus the current analyst expectations will play into moves in stocks in January and February? Which is more important? YoY or current analyst consensus in this unique sitution?
I prefer to focus on the quarter as an individual event rather than using year over year comps – particularly considering how useless (unique) Q4 2008 is. Sequential figures are much more useful in gauging the recovery in earnings.
TGP,
Please don’t take offensive at this, but this site often seems to mirror the daily market action (trend) just like the MSM. The past couple of days when the market was down almost all the posts were bearish. Today with the future and now the market up, the posts so far are all more or less bullish.
I have always found it interesting that CNBC has Rosenberg, Pretcher, and other bears on when the markets are down. When the markets are up the bears are rarely to be seen.
TGP is much more balanced, but on a day-by-day basis there appears to be a similar correlation.
Thanks for pointing that out Rob. Most of what you read every day is written the night before (this article for instance was written last night) so either my time machine is working overtime or it is pure coincidence. I really try to keep it balance so thanks for pointing this out though. I’ll keep it in mind for future reference.
Hi TPC, it would be nice that a date and time ba part of any post so confusion could be minimized. Thanks in advance.
Based on earnings comparisons with P/Es at near record highs, if earnings were to recover to 2007 levels the Dow and S&P would be at 25,000 and 3,000. This may be possible if we have permanent 0% interest rates and 0% inflation, but the likelyhood of it happening is also 0%.
Given that we seem to have 50% permabulls expecting a V recovery mirroring 2003-2007 and 50% E-Wave expecting second 50% downleg. The contrarian position seems to be that both will be wrong.
I agree with Louise Yamada and long term K Wave analysis that this is a secular bear market starting in 2000 following the 1929-1942 scenario. This predicted the 2008 crash (aka 1937) and predicts a 12 mn plateau around Dow 10K to 11K before more downside. Interestingly this also sets up a huge head&shoulders for the Dow.