An Earnings Trend That Can Lead to Profits for Investors

Men looking at stock quotes at Nasdaq MarketSite
Credit: Reuters / Gary Hershorn - stock.adobe.com

Today is the last trading day of July and we are about halfway through the Q2 earnings season. Let’s step back for a bit and take stock of what we have learned from the earnings releases so far. It seems like two things are clear. First, analysts continue to underestimate the American economy and the companies that drive it, and second, the market is beginning to reflect their pessimism.

The underestimation of earnings is nothing new. On average, over the last decade or so, more than two thirds of companies have beaten Wall Street’s consensus forecasts for Earnings per Share (EPS) each quarter. That raises a question as to why we even bother to pay attention to those estimates. I mean, if you were wrong 70% of the time in your job, you would probably be let go. Even famously inaccurate weather forecasters have a better strike rate than that these days!

Still, the fact remains that analysts' estimates are influential, so it is important to understand why they consistently miss on the low side. The answer to that seems to be, in part at least, that the starting point for their calculations is usually the company’s own guidance for their earnings. If you are a CEO forecasting performance, it obviously makes sense to under promise and over deliver rather than the other way around. As a result, guidance, the starting point for estimates, is generally conservative.

And yet, when a company issues lower than expected guidance, their stock gets hit. I know that seems sensible on the surface, but since we know that they are habitually underestimating, most of those selloffs are buying opportunities.

A good example of that came yesterday, when First Solar (FSLR) released their results. They beat expectations for EPS, but lowered guidance for the next quarter. This led to their stock dropping close to 5%. They also lowered guidance in their Q1 report three months ago, which is why estimates for Q2 EPS came in at only $0.60 versus the $0.77 achieved. FSLR bounced back strongly after that, so why should it be any different this time? (I should say at this point that I have put my money where my mouth is and am currently long on FSLR).

That scenario is also playing out in a macro sense. The market overall has basically stalled, even as companies are reporting great earnings.

S&P 500

On average, S&P 500 earnings are up 86%. Obviously, that result is as compared to an exceptional quarter last year, but the average beat of expectations is 18% this quarter as compared to around 5% historically and earnings are now way above pre-pandemic levels. However, if we look at the chart above for S&P 500 futures that dates back to the first real day of earnings this season on July 13, you can see that they opened that day at 4,377 and are trading at 4,378.5 as I write this morning. An 86% jump in earnings, beating expectations by 18% has resulted in the index futures gaining 1.5 points.

If that makes no sense to you, join the club. I understand that traders and investors are worried about slowing growth, the Delta variant, and the Fed, but those same worries were around three months ago. Yet here we are, up 10% or so, smashing records for earnings growth. Ultimately, it comes down to which you trust more: your so far unjustified fears, or the cold, hard facts of massive and increasing profits.

I am sticking with the latter, so if a company that has a history of beating its own guidance gets hit because that guidance is lower than anticipated this time, I will continue to see that as a chance to pick up a good stock at a discount.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Martin Tillier

Martin Tillier spent years working in the Foreign Exchange market, which required an in-depth understanding of both the world’s markets and psychology and techniques of traders. In 2002, Martin left the markets, moved to the U.S., and opened a successful wine store, but the lure of the financial world proved too strong, leading Martin to join a major firm as financial advisor.

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