To no surprise of TPC readers, earnings are coming in much better than expected. The median surprise is almost 7%. There have been 5 surprises for every miss so far. 32% of the companies reporting are showing year over year growth. On June 11th we mentioned the likelihood of better than expected earnings:
My preliminary glance at Q2 estimates and overall earnings leads me to believe that it will be a very bad idea to be short heading into this next earnings season unless estimates jump in the next 6 weeks. Alcoa doesn’t report until July 7th and earnings will pick-up momentum in the two weeks after. I still believe the market could run into some resistance between now and then, but as of now the earnings trends bode well for stocks.
We followed that up in late June with a more detailed report describing the likelihood of massive cost cutting leading to better than expected earnings and stock rally:
The implications here are that we are likely to see another quarter of “better than expected” bottom line earnings as analysts have adjusted their EPS estimates very little over the prior quarter. This could further juice the stock market.
Although the quality of the earnings are very poor it’s important to put things in perspective. As we’ve learned over the last two weeks the market doesn’t always judge the quality of an earnings report on its own, but rather against the estimates of a handful of very powerful and horribly misguided analysts. It is due to this that I use my proprietary expectation ratio. This ratio is intuitive, forward looking and compares current outlooks to future analyst outlooks. The ER topped out in late 2007 and bottomed in late 2008. Although I had been witnessing earnings deterioration since late 2006 the earnings did not begin to deviate from analysts estimates until late 2007 when the market began to falter. This shows the power of the analyst community and the important in understanding their data.
Although I am less than optimistic about the prospects of a sharp economic recovery we have to respect the fact that analysts estimates are still very low. This means we are likely to continue seeing earnings strength in the weeks and months ahead. We’ll gauge Q3 when we get closer, but for now the earnings picture looks very strong compared to how poorly analysts were prepared for it. As you can see, the ER has spiked higher again after a brief decline:
Wall Street firms raised forecasts on Standard & Poor’s 500 Index companies 896 times in June and lowered 886, according to data compiled by JPMorgan Chase & Co. The last time analysts were bullish on a net basis was in April 2007, before more than $1.5 trillion of bank losses tied to subprime loans spurred the first global recession since World War II, the data show.
But don’t be fooled. Although you might be baffled by the recent rally your skepticism is not necessarily misplaced. The underlying fundamentals of this rally have been very poor – just not as poor as those geniuses in the NYC skyscrapers expected. David Rosenberg puts the earnings strength into perspective:
According to S&P, only 61% of the companies have beaten their low-balled profit estimates. Yet as we saw in the first quarter, this is being accomplished via aggressive cost-cutting efforts. With 53% of the S&P 500 universe reporting, revenues are down about 10% YoY and the worst is yet to come because the retailers and homebuilders have yet to report. Even so, on an apples-to-apples comparison, sales were -16% YoY in 1Q and -14% in 4Q of last year, so the bulls (who have thus far been correct) would say that this is a classic ‘green shoot’ second-derivative improvement in the data. The revenue declines have cut a wide swath, with 9 of the 10 sectors and 3 in 4 companies posting contractions.
For those believing the recession is over, let’s just say that in the context of an economy that is not in recession, the odds of seeing a negative quarter for revenues is 1-in-13. And, just how bad is a -10% quarter for sales revenues? Well, it would tie the fourth worst performance of the past decade. To put it into perspective, when the 2001 recession ended, sales were running at -1.0% YoY — what we have now is worse by a factor of ten. And, when the last bull market was confirmed in the spring of 2003, sales had already swung well into positive territory on a YoY basis.
The quality of these earnings are very poor despite what you might be hearing in the mainstream media. Cost cuts are a defensive measure taken by companies that are concerned about the future well-being of the company. While it is a near-term positive, it is not a recipe for sustainable growth. For now, you simply can’t short the market during earnings. The weeks ahead are loaded with consumer discretionary and materials names. Not a single consumer discretionary name has missed earnings so far. Materials are far worse, but any (supposed) strength in consumer names could overshadow this. But don’t be surprised if the weak fundamentals of the economy reassert themself as soon as earnings season ends and the foolish analysts estimates stop impacting market direction on a daily basis.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.