Posted by on Sep 3, 2012 in Articles & Advice, Blog, Columns, Featured |

Image Credit: Christophe Vorlet

By Jason Zweig |  Aug. 31, 2012 8:14 p.m. ET

Bad is the new good.

On Monday, Tiffany & Co. announced that its quarterly earnings had fallen one penny a share short of Wall Street’s expectations and that profits for the full year would run 10 to 15 cents lower than the luxury retailer had previously indicated. The stock promptly rose 7%.

On Wednesday, Joy Global, a maker of mining machinery, announced that its earnings for the quarter came six cents short of the average prediction on Wall Street and that revenue in 2013 would be “flat to down slightly.” The stock closed nearly 3% higher.

When companies miss Wall Street’s earnings expectations, their stock prices typically tumble.

By what warped logic, then, have bad results become good for stock prices?

“What I heard from a number of analysts and investors,” says Mark Aaron, Tiffany’s head of investor relations, “was that they were relieved that the quarter wasn’t worse and that we didn’t reduce guidance for the year more than we did.”

Executives at Joy weren’t available for comment, but “investors were waiting to get the bad news behind them,” says Andy Kaplowitz, an analyst at Barclays Capital who follows the company. “Investors knew the quarter could be messy, and they already had more realistic expectations than the Wall Street consensus. So it’s a relief rally.”

Wall Street used to have just “the number,” the official average or consensus of all the analysts who follow a stock. Then came the “whisper number,” the nudge-nudge-wink-wink figure that a company hinted it might earn. Now, it seems, Wall Street has the “worry number” — a figure reflecting the worst fears of investors that analysts and the company alike might be painting too rosy a picture in a rotten economy.

The typical company has done such a good job dumping ice water on the hopes of analysts and investors that it has managed to beat the consensus forecast of earnings. This is the 13th out of the past 14 quarters in which at least two-thirds of S&P 500 members exceeded the official forecast, according to Bianco Research.

Sure, some stocks still have gotten crushed on earnings disappointments; nine members of the S&P 500 lost at least 10% in a day when they missed the target this quarter.

But on average, negative earnings surprises have been doing less damage than usual. According to Birinyi Associates, the 109 stocks in the S&P 500 that came up short of official expectations this quarter lost 2.2% the next day, down from a 3% loss in the second quarter and a 4.7% decline in the third quarter of 2011. The long-term average is a 2.5% loss.

It is as if companies have fallen short of the official number but beaten the worry number — making bad results look better than investors had secretly feared.

Perhaps the soul musician Lyfe Jennings had it right when he sang in 2010: “So no matter how bad you think it hurts, it coulda been worse…You coulda lost everything, you shoulda lost everything…It coulda been worse.”

New research by a team of neuroscientists at Emory University shows that business-school students investing in stocks who were confronted with negative earnings surprises experienced a steep drop in activity in the ventral striatum, an area of the brain that responds to rewards. (The investors learned about the stocks while their brains were monitored inside a giant magnetic scanner.)

The researchers found that what determines how an investor’s brain responds to an earnings report isn’t the size of the company’s gain or loss, but whether the gain or loss is better or worse than expected. That likely occurs regardless of whether the expectation is set by the Wall Street consensus or by an investor’s own worry number, says Jan Barton of Emory, one of the study’s authors.

So when investors expect a severe shortfall, anything better — even if it is still bad — will feel positive and surprising.

The trick isn’t to take such “surprises” too seriously.

If you own a company that reports bad earnings and whose shares then go up in price, that is nice — but it hardly is cause for celebration.

On the other hand, if the stock drops on disappointing earnings, ask whether the prospects of the underlying business have changed.

Altering your long-term investing plan based on one bad quarterly report makes sense only if there’s good reason to believe the business has suffered lasting damage.

One simple way to cope with surprise is to rehearse for it. Mentally chop 25% off the value of each stock you own, then ask whether you would be happy to buy more at the new, lower price. If the answer isn’t yes, maybe you shouldn’t own it at all.

Source: The Wall Street Journal,

For further reading:


Jan Barton et al., “The Neuroscience Behind the Stock Market’s Reaction to Corporate Earnings News

Douglas J. Skinner and Richard G. Sloan, “Earnings Surprises, Growth Expectations, and Stock Returns: Don’t Let an Earnings Torpedo Sink Your Portfolio