There is one thing that relatively new traders and investors really have to understand. Most are aware that what matters when it comes to a company’s earnings is how they do relative to expectations, but not many understand that those estimates are inherently biased in one direction and how essentially meaningless that makes those comparisons to consensus forecasts.
So far this quarter, for example, with just under one half of S&P 500 having reported, over 80 percent of them have posted beats in terms of EPS. That is more than average, but lest you think it is indicative of any serious strength, I should point out that the average for EPS beats over the last five years runs at around 75 percent. That is a crazy number. You would think that if analysts are consistently wrong in one direction three quarters of the time, they would adjust their calculations and models to account for that. But they don’t. And this is because being consistently wrong to the downside suits everyone. Everyone, that is, except maybe investors who want to stay informed as to what is actually going on.
It suits the analysts themselves. If they underestimate profits regularly, they may be inaccurate, but their guesses then rarely do a lot of damage. No customer of the bank can call them up and say, “I lost money because you convinced me to buy XYZ by overestimating their profits for last quarter.” For banks, particularly since 2008, that is far more important than accuracy could ever be. And it suits the CEOs and other senior managers who the analysts are supposedly judging when they make their estimates. It allows a company’s c-suite to report beats consistently, making them look good even when the results are really anything but. It is an institutionalized version of “under promise and overdeliver,” and it helps to support some pretty hefty salaries and bonuses.
The problem for those of us who don’t get paid big salaries for playing this game, though, is that the reality of earnings seasons is often hard to see. Take the earnings so far for last quarter, for example. As I said, over 80 percent of companies are beating expectations, but most are also reporting earnings that have declined compared to the same quarter last year for the third consecutive time. I know that certain assumptions are usually priced into stocks before earnings season begins and that the relative performance is therefore important, but in a quarter like this where the market has been posting strong gains for a few months, that is less relevant in a lot of ways.
As a result of that strength on strength, the 1-year chart for the S&P 500 above shows that the index is currently around 15 percent higher than it was a year ago, and that is despite three consecutive quarters of falling corporate profits. It can be argued that that is because the drop in the second half of last year was overdone and that it is also to do with expectations for an end to rate hikes and even a policy reversal by the Fed early next year at the latest, and I get that. But still, stocks heading higher as profits decline is just not a sustainable trend.
One of three things has to happen. Corporate profits have to recover strongly, stock prices have to adjust downwards to bring the earnings multiple of stocks in general back to their long-term average, or that average itself has to increase. That doesn’t mean that the market has to adjust lower, but it does make that far more likely than it may seem with over 80 percent of companies posting bottom line beats.
So, as you continue to hear about companies beating expectations for EPS, understand that that is not as impressive as it sounds. They are beating estimates that are quite deliberately kept low to benefit both the analysts and those whose performances they are assessing. And while that can produce results that look good on a relative basis, investors should keep the absolute picture in mind.
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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