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.
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.