The Quarterly Wall St. Lie
We’re neck deep in an already rocky October, and that can only mean one thing for the stock market: It is time to hype and spin everything, once again.
With less than three months left in the year, the clock is running out to meet targets and make companies look as healthy as possible.
Earnings season is ramping up, ladies and gentlemen, and that means companies are about to self-congratulate themselves once again.
And, as always, the time has come to do everything possible to sculpt easy sound bites for the talking heads and market cheerleaders to play along, glossing over reality and explaining why everyone should buy everything, forever.
There is a sneaky maneuver that is consistently used to game the earnings announcements that we’ll see over the next several weeks.
Early earnings estimates are set nice and high, followed by a steady stream of lower revisions, a couple pennies at a time, as it gets closer to when earnings will actually be stated.
After all, companies and analysts want to portray strong growth in the near future. This is especially true when stocks are expensive on an earnings-per-share basis, as they are now (even after the correction).
Then, right at the end, there is a surprise pop, and real earnings beat the lowered expectations. The companies “beat” what “everyone” thought was reasonable. Back patting and cocktails for everyone!
In spite of earnings coming in well below what was previously expected, a carefully managed view that companies outdid themselves is consistently maintained.
This Is Hardly New
Back in July of last year, Deutsche Bank’s chief U.S. equity strategist, David Bianco, called out this “fish hook” pattern, explaining quite succinctly how to properly gauge a company’s health:
“The recurring “fish hook” pattern in quarterly bottom-up S&P EPS pre and post reporting is a charade, leading to common but specious stats that two-thirds of companies beat estimates usually by a 3% weighted average.
“For this reason, we have long stressed the irrelevance of judging earnings season by meet/miss ratios or the average beat. We focus on y/y EPS growth with an eye toward operating measures that exclude litigation and indicate underlying growth such as y/y sales growth. On this basis, S&P EPS growth is weak this 1H and most of the past few years.”
Here is the chart he provided at the time, showing how this has consistently panned out over the last five years, though it has been going on for far longer than that:
I couldn’t agree with Mr. Bianco more. If we focus on earnings growth and indicators of underlying growth, such as sales or revenue growth, there is no way to justify what has been going on for the last year and a half.
Here are some of the latest key statistics about this quarter, coming from FactSet:
- For Q3 2016, the estimated earnings decline is -2.1%. If this holds true, this will mark six back-to-back quarters of earnings declines, which hasn’t happened since FactSet started tracking the data in Q3 2008.
- For this quarter, of the 114 companies that issued guidance, 80 companies in the S&P 500 have issued negative EPS guidance and 34 have issued positive EPS guidance.
- This could be the first quarter since Q4 of 2014 to actually post modest revenue growth of 2.6%. in spite of the six quarters of falling revenue, the S&P 500 is up about 9%.
Regardless of the positive spin that will be presented in the MSM, there is no way around the fact that earnings are a disappointment, and the market has posted gains without any fundamental support.
So What Does It Mean?
The most obvious conclusion from all of this is that there is little interest in focusing on reality in most financial news outlets.
The frantic pace must be maintained. No CNBC interview can last more than five minutes. All opinions must be stated as fact, be devoid of context, and clock in at under 10 seconds.
The next conclusion is we need to act on our own with more illuminating, longer-term information. Investors are not spoon-fed information that is useful to us. All we get is what is useful for them to have us know, or what they want us to think.
Finally, looking forward, we should severely doubt the staying power of any rallies. There will always be plenty of spin, but reality ultimately sets in.
There is a lot wrong with the U.S. stock market, and China, Europe, and emerging markets don’t deserve to take the blame because of the collective, willful ignorance of investors.
As one final note, check out this chart. Forward EPS isn’t my favorite metric, by far, but it shows what has happened quite well when the market got too far ahead of earnings:
Even after a couple brief corrections, the divergence between prices and earnings estimates remains wide.
If the S&P 500 fell back in line with forward EPS guidance, which is often overly optimistic, we’d be back down around 1885.
The index first passed that mark in 2014, and it would erase over two years of gains.
But, of course, you’d never know that there is still plenty of downside risk visible in more meaningful indicators if you never questioned the quarterly earnings season charade.