EXPECTATION RATIO HITS 2010 LOW
Earnings season is winding down and despite what you’ll hear from market bears, it is shaping up to be another good one – even better than we expected. As we often say, the market is an expectations game and not a reality game. Although the actual figures are not showing robust organic growth the data was substantially better than investors expected. As of February 16th just under 80% of the S&P 500 has reported earnings and 72% have outpaced analyst’s expectations. Just 19% have missed estimates. Perhaps more reassuring is some sign of revenue growth. Total revenues are higher by 6% on a year over year basis – certainly not a blockbuster figure, but growth nonetheless. The standout has been tech which has seen 53 upside surprises and not a single miss.
Many market pundits and analysts remain skeptical of the data due to the underlying weakness, but I fear they are misinterpreting the market implications. After all, if we simply looked at the reality of the economy and earnings (as opposed to the economy and earnings in comparison to expectations) the market would likely be flat when compared to a year ago. Clearly, that is not the case as earnings and economic data continue to outpace a skeptical investing public. David Rosenberg has gone so far as to say the earnings beats are a “fraud”. He goes on to explain how easily firms can manipulate and beat earnings:
“Everywhere you look these days you can’t help but find a reference as to how nearly 80% of S&P 500 companies have managed to surpass their earnings estimates and the current edition of Barron’s added that they “have beaten estimates by a staggering 11%, near the highest on record.” This, of course, is a reason to be bullish on the equity market.
But page B1 of the weekend WSJ exposes these earnings “beats” for what they are — fraudulent, for lack of a more appropriate term — see For Some Firms, a Case of ‘Quadrophobia’. A just-published study covering nearly 500,000 corporate results over 27 years found how companies “round up” their numbers to beat their estimates fractionally knowing that the fast-money momentum players will trade the stock price higher. On average, it only takes $31,000 in quarterly net income to beat estimates by a penny, which can be handled easily by a tweak to inventory valuation. The report also showed that companies that find ways to “round up” are also the ones with the highest propensity for re-statements in the future. Well worth a read and hopefully ends the nonsense that we see in the media and Wall Street reports over the extent to which financial results are meeting or beating pre-conceived EPS projections.”
While this might be true historically, it is not necessarily applicable here. Companies are beating by a 6% margin vs the historical norm of 3%. In most cases this is not just “one penny”, but several pennies – a big difference in the world of earnings outperformance. If Mr. Rosenberg is upset with the high level of beats he would be wise to tell is fellow analysts to increase their estimates as they remain very low. As we have been saying for the past 5 quarters estimates remain woefully low as the analyst community simply has no clue how strong corporate income statements are. That is likely to continue in the immediate quarters.
Although our expectation ratio inched lower over the last month it remains in firmly positive territory. I fully expect the next quarter to reflect what we have been seeing in recent quarters – a HUGE number of beats and “better than expected” headlines to be splashed all over the news. The estimates should continue to ratchet up in the coming quarters and I see very little risk in the profit picture until later in the year. If the ER continues to trend lower the market will be waving a serious warning flag as earnings will be likely to disappoint in H2. We’ll keep you posted.
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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8 Comments
We are headed for the biggest recession ever for the United States. If we are a country which relies on consumption then we are done for. Since our manufacturing jobshave gone to other countries it’s just a matter of time before bankrupcy will be upon us. The world will also falter. Japan, Korea, Germany, and China soley depend on exports. Who is going to buy their products? However china can absorb it’s own products. The people, state government, federal government in the US are broke. The lifestyle in the US will change dramatically.
TPC, how low does the ER have to go for you to get bearish? I think some heavy selling is on the horizon, i.e., 1-3 days.
i’ll take that bet
What did I win!!!????????
haha…
Bear in mind the ER is made up of several income statement and balance sheet components and is only used to measure the future strength of corporate earnings and financial condition when compared to expectations. The trend is important, but a move below 1 would likely mean expectations are too high and corporations are ripe to miss earnings estimates.
I think we’re in for one more quarter of really solid earnings and then things get dicey. Q2 looks like it will be mostly in-line as of now and Q3 earnings are simply thru the roof. If the economy does not improve SUBSTANTIALLY from here we will not meet those lofty expectations.
i think if you invest one quarter at a time and keep your stops tight, you might get the equivalent of a walk, steal of second, bunt over to third and sacrifice fly…not pretty but you can chalk it up
I think governments in the west through money at the problem without even thinking to do something about it. The money is gone (we know where), the problem is still there. It is structural. It is going to be very painful.
There are opportunities, because even in the worst of the crisis you can spot opportunities, but what we have in front of us is a shift of power of historical proportions.The financial crisis is the signal that something is ongoing, then we will see the other implications unfold in a few years. We need to rethink our way to stay on global markets if we want to survive and be successful.
thanks for the update.
but you still get it wrong imo:
“…As we have been saying for the past 5 quarters estimates remain woefully low as the analyst community simply has no clue how strong corporate income statements are. That is likely to continue in the immediate quarters…”
underpromise – overdeliver that both the companies and the analysts community are playing TOGETHER since it is one important part of the positive psychology puzzle that moves stocks higher, making ceos happy and guaranteeing analysts jobs.
i suspect that after the lehman crash the game was changed a bit that companies and analysts alike have increased their safety margin.
(remember – you have to convince a depressed investor crowd to bid up stocks again.)
despite huge beats during this earnings season many stocks did not react, but even declined.
those good earnings have clearly been built into stock prices although not shown in analysts estimates.
the trick is to figure out, what the new “real beat” margin is.
a 5% beat might have been great in the past, but now it´s only in-line.
and a one penny beat or even an in-line report could in reaility be seen as a miss by the market.
good article on the topic bei R.Bernstein: http://www.businessinsider.com/richard-bernstein-the-charade-of-earnings-surprises-2009-7