Summer is over, October is here, and that can only mean one thing for the stock market. It is time to hype and spin everything.
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.
This week in particular marks the start of it all. We’re entering earnings season yet again, ladies and gentlemen.
And, as always, the time has come to do everything possible to sculpt easy sound bites for the talking heads and market cheerleaders to gloss over and explain why everyone should buy everything, forever.
The Game
There is a sneaky maneuver that is consistently used to game the earnings announcements that we’ll see over the next several weeks.
Check out a chart of how it pans out over time:
It is impossible to miss the trend. Early estimates are high, followed by a steady stream of revisions 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 pop and earnings beat the lowered expectations. The companies “beat” what “everyone” now thinks is reasonable.
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 this year, Deutsche Bank’s chief U.S. equity strategist, David Bianco, called out this “fish hook” pattern:
“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:
Reality Check
I couldn’t agree with Mr. Bianco more, across the board.
If we focus on earnings growth and indicators of underlying growth, such as sales increases, there is no way to apply a rosy tint to what is coming in the next couple weeks.
Here are some key statistics, coming from FactSet:
- For Q3 2015, the estimated earnings decline is -5.1%. If this holds true, this will mark the first back-to-back quarters of earnings declines since 2009.
- This earnings decline would also mark the largest year-over-year decline since Q3 2009.
- For this quarter, of the 108 companies that issued guidance, 76 companies in the S&P 500 have issued negative EPS guidance and 32 have issued positive EPS guidance.
- The estimated sales decline for this quarter is -3.4%, which is also higher than the estimated year-over-year revenue decline of -2.5% at the start of the quarter.
- For all of 2015, analysts are projecting earnings to grow by 0.5%, but revenues to decline by 2.6%.
Regardless of the positive spin that will be presented in the MSM, there is no way around the fact that earnings have and will continue to disappoint.
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 conclusions must 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 unless everything is perfect, which is most certainly not the case.
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 the correction, 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 1800.
We haven’t seen the index there since the beginning of 2014, and it would erase nearly 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 didn’t take a second to question the earnings season charade.
