Image Credit: Christophe Vorlet
By Jason Zweig | July 2, 2011
Everyone loves surprises. But perhaps you shouldn’t get too excited over them.
This month, market strategists, television commentators and other investing pundits will bombard you with breathless updates on the percentage of companies in the Standard & Poor’s 500-stock index that have reported profits even higher than what analysts expected—in Wall Street lingo, a “positive earnings surprise.”
The percentage of companies that have beaten expectations often is cited as a barometer of corporate profitability, an indicator of how well the economy as a whole is doing or a predictor of where the stock market is going.
What goes unsaid, however, is that these positive surprises are becoming so common they are nearly universal. They are predetermined in a cynical tango-clinch between companies and the analysts who cover them. And there is no reliable evidence that the stock market as a whole will earn higher returns after periods with more positive surprises.
In the first quarter of 2011, according to Bianco Research, 68% of the companies in the S&P 500 earned more than the consensus, or median, forecast by analysts.
What’s more, that quarter was the ninth in a row when at least two-thirds of the companies in the S&P generated positive surprises—and the 50th consecutive quarter in which at least half of the companies surpassed the consensus forecast of their earnings.
Even in the depths of the financial crisis, from the third quarter of 2008 through the first quarter of 2009, between 59% and 66% of companies beat expectations, according to Wharton Research Data Services, or WRDS.
In short, there isn’t anything surprising about earnings surprises. They aren’t the exception; they are the rule. “All the numbers are gamed at this point,” says James A. Bianco, president of Bianco Research.
With trading volumes down on Wall Street and commission rates near record-low levels, brokerage firms are starved for the revenue that stock trading used to provide. Since changes in earnings forecasts encourage many investors to buy or sell, analysts have an incentive to revise their predictions more often. But that hasn’t made the forecasts more accurate. On average, according to Denys Glushkov, research director at WRDS, stock analysts are revising their earnings forecasts nearly twice as frequently as they did a decade ago. And while the typical forecast missed the mark by 1% in the 1990s, that margin of error has lately been running at triple that rate.
What’s going on here? In what used to be called “lowballing” but now goes by the euphemism of “guidance,” an analyst will guesstimate what a company will earn over the next year or calendar quarter. Then the company “walks down” the analyst’s forecast by providing a series of progressively lower targets until the analyst’s prediction falls slightly below where the actual number is likely to come out.
Voila: The company gets to announce earnings that are better than expected, while the analyst gets to tell his investing clients that his estimate was pretty accurate and conservative to boot.
According to a survey of 269 members by the National Investor Relations Institute, 90% provide guidance in one form or another, most commonly on earnings and revenues over the coming four quarters. No more than 5% offer any guidance on results further than one year into the future.
Refusing to dance this cynical tango isn’t always easy. “If you cut back or eliminate guidance, management needs to be prepared for the possibility of more volatility in the stock price and a wider range in analysts’ estimates,” says Barbara Gasper, head of investor relations at MasterCard, which doesn’t give short-term guidance. Instead, it provides three-year targets for sales and profitability, leaving analysts at least partly on their own to form interim forecasts of the company’s earnings.
Somehow, the stock has survived.
You might think that positive earnings surprises would be good for future returns of the stock market overall. Companies that report positive surprises still get a short-term pop in their stock price, even though the smartest investors realize the surprise is a staged event.
In any case, the pop in those stock prices tends to fade over time. And an increase in the proportion of companies reporting positive surprises in one quarter, says Mr. Glushkov of WRDS, “does not have consistent forecasting power for S&P 500 returns in the next quarter.”
With analysts playing the guidance game more than ever, their forecasts tell us less than ever about where the stock market is going. So over the next few weeks, don’t be fooled into thinking that there is anything surprising about the flood of positive earnings surprises. And don’t believe anyone who tries to tell you that these fake surprises mean nothing but good times are ahead for the economy and the stock market.
Source: The Wall Street Journal, https://www.wsj.com/articles/SB10001424052702303763404576419783497869132
For further reading:
Definitions of ANALYST, CONSENSUS, EARNINGS SURPRISE, FORECASTING, SURPRISE, and UNCERTAINTY in The Devil’s Financial Dictionary
Chapter Eight, “Surprise,” in Your Money and Your Brain
Lawrence D. Brown et al., “Inside the ‘Black Box’ of Sell-Side Financial Analysts”
Mark T. Bradshaw, “Analysts’ Forecasts: What Do We Know After Decades of Work?“