Good morning. Well, it's that time of year again - earnings season. If you've been at this game for any length of time, you know that this is where things really get interesting. This is where the rubber meets the road, where the estimates meet with reality (oops, I mean where the highly paid analyst guess work meets with reality), and where themes develop for companies, sectors and the market as a whole.
This is also where the algorithms that control the vast majority of trading in the market take over and logic oftentimes goes out the window (although, in reality, conventional logic rarely has much to do with the stock market). For example, companies that beat analysts' expectations in terms of earnings per share (EPS) but miss the consensus estimate for their revenues - or say something conservative about the future - are likely to get hammered. And on the other hand, should a company produce a "triple play" by beating EPS and revenue expectations, and then increasing their "guidance" (the company's own internal guesswork relating to future earnings) for the upcoming quarter, the stock will be handsomely rewarded.
Especially at this time of year, it is important to remember that this game is all about expectations versus reality. So, while it does indeed sound silly that stocks will react violently to a report that doesn't match expectations - even though the analyst estimates that the report is being compared to are rarely, if ever, accurate - this is the reality of the earnings game. And what's worse, the bottom line is that "reality" tends to be a moving target in this business.
My primary point this morning is that it is important for investors to understand what the game is about during earnings season. Investors first need to know what is generally expected of the earnings parade before it begins. And then they also need to be able to keep score of how the earnings season is progressing. As usual, we will do our best to assist on both counts.
Over the past two quarters, the trend of the earnings season has emerged early and has been unmistakable. In sum, companies have done a pretty decent job of beating expectations on the "bottom line" (EPS) but have consistently missed on the "top line" (revenues). The key here is to understand that companies can play all kinds of games in order to financially engineer a "beat" in terms of their EPS number, but revenues are tougher to mess with.
This theme of companies consistently missing revenue numbers helped confirm the idea that the economy was slowing this summer/fall. But with the focus lately having been on the election and all the fiscal cliff nonsense, it will be interesting to see if the "revenue light" theme persists again this quarter. Alcoa kicked things off yesterday with a report that was the exact opposite of this theme - AA missed EPS by a penny but beat revenues handily. The company also said that things were looking up in China. And should this theme be reinforced in the coming weeks, it is a safe bet that the indices will enjoy a nice ride higher.
Looking At The Numbers
So, since the earnings parade doesn't really get rolling until next week, I thought it would be a good idea to spend a couple minutes exploring the expectations for the current earnings season. So let's get to it. According to FactSet, the S&P 500 EPS estimate currently stands at $25.47 for the 4th quarter. This would represent an increase of 2.4% for the quarter, which isn't exactly robust. In addition, this estimate is down from the 9.2% growth rate that was expected at the start of the quarter. In other words, the expectations for EPS growth have fallen dramatically over the last three months.
In terms of the revenue growth expectations, the FactSet estimate is for 2.1% in Q4. This is down from the 2.7% growth rate that the firm had on September 30th. This occurred because, according to FactSet, 78 companies issued negative EPS guidance for Q4 during the pre-announcement period, while only 32 issued positive EPS guidance. This means that 71% of the companies warned that earnings would be below current expectations. This is about ten points above the five-year average, but also below the 78% negative guidance rate seen last quarter. FactSet also points out that the reason behind the declining outlook is simple: the lingering macro overhang relating to the economy and global growth.
Because of all this, I will be watching the upcoming earnings parade with particular interest. My goal will be to try and determine if the much ballyhooed "uncertainty" surrounding the fiscal cliff, the talk of delayed capital investment and hiring, the slowdown in Europe, and the effects of Superstorm Sandy will actually show up in the numbers. Most analysts expect to hear a lot of excuses and to see a rather punk parade. But, I'm going to withhold judgment for now and see what I see as the numbers roll in.
Publishing Note: I am traveling for the remainder of the week will not publish a report. Daily State of the Markets reports will return on Monday.
Turning to this morning ... Things are fairly quiet again this morning. Overnight markets were modestly higher as Alcoa's (AA) comments about China being on the comeback trail helped buoy the mood. There are no economic inputs to guide traders today and no major earnings reports. U.S. futures are currently pointing to a modestly higher open on Wall Street.
Here are the Pre-Market indicators we review each morning before the opening bell...
Major Foreign Markets:
- Shanghai: -0.05%
- Hong Kong: +0.46%
- Japan: +0.68%
- France: +0.06%
- Germany: +0.05%
- Italy: +1.20%
- Spain: +0.49%
- London: +0.39%
Crude Oil Futures: -$0.10 to $93.05
Gold: -$2.30 to $1659.90
Dollar: lower against the yen, higher vs. euro and pound
10-Year Bond Yield: Currently trading at 1.879%
Stock Futures Ahead of Open in U.S. (relative to fair value):
- S&P 500: +3.30
- Dow Jones Industrial Average: +28
- NASDAQ Composite: +4.28
Positions in stocks mentioned: none