“A little help, please!” So reads the subject line of an email I received yesterday. The reader was responding to my sermon about the supreme importance of earnings in determining future stock prices. Specifically, the troubled reader wanted to know exactly which earnings metrics to monitor.
The request is certainly timely. Earnings season is now officially underway after aluminum giant, Alcoa (AA), kicked things off on Monday. And as a headline at MarketWatch points out, earnings are, indeed, the “1st big stock test since the market high.”
As you know, I’m always eager to lend a helping hand. But before I share the only two metrics you need to be tracking, I must reiterate a warning I made last fall …
What is Alcoa Good For?
Although the practice remains popular with many investors, treating Alcoa’s results as a bellwether for the rest of the stock market is a big mistake. It’s a mistake that could cost trillions in lost profits if investors act on a bad interpretation of the data.
In reality, Alcoa’s results are good for … well, absolutely nothing when it comes to predicting the trajectory of stock prices. In case you need a refresher on why, pick your poison…
Or you can hear it from two more seasoned veterans…
- Whether or not “Alcoa beat or meet earnings, that’s a meaningless headline,” says Edward Dewees of Douglas C. Lane & Associates, who helps oversee about three million Alcoa shares.
- “[Alcoa's] results now predict the direction of the market about as well as a coin flip,” says Ryan Detrick, analyst at Schaeffer’s Investment Research.
Now, the question is, if we don’t look at Alcoa’s results for guidance, then what earnings stats should we focus on? Glad you asked …
Just Beat it, Beat It!
Go ahead and dust off the cassette tape and cue up Michael Jackson’s 1983 hit, “Beat it!“
It’s the most appropriate theme song for the first-quarter earnings-reporting season. Because the only two metrics we should be tracking are the earnings “beat rate” and the revenue beat rate.
Both measure the percentage of companies that beat expectations for earnings and revenue. Simply put, the more beats, the better. Especially considering that many analysts have been aggressively lowering their forecasts.
Collectively, they now expect S&P 500 earnings to rise about 1.5%, down from a 4.5% growth rate at the beginning of the year. They’re obviously afraid that bad news is on the horizon. But don’t let that scare you out of stocks just yet. Analysts are notorious for being wrong. And we’ll find out if that’s the case again shortly.
As you can see in the chart below, earnings reporting season doesn’t kick into high gear until the week of April 22.
Sizing Up Expectations
On the earnings front, analysts lowered projections based on fears that American consumers have pared back spending in the wake of so much global uncertainty. Yet the data suggests otherwise.
For instance, consumer credit jumped the most in six months in February, according to the Federal Reserve. I’m with S&P’s Howard Silverblatt, when he says, “The consumer is still spending mostly because they’re tired of hearing how the world is coming to an end.” Tired, indeed. Add it all up, and the stage is set for a strong percentage of companies to report better-than-expected earnings.
In terms of actual numbers, the earnings beat rate checked in at 61.4% last quarter. So any reading above that would be strongly bullish. And any reading above 58.7%, which is the low since this bull market began, should pave the way for higher stock prices.
On the revenue front, analysts’ downbeat projections stem from fears over companies suffering from exposure to the downturn in Europe. But again, they might be overestimating the impact. According to S&P data, only about 14% of sales for S&P 500 companies comes from Europe.
In terms of actual numbers, the revenue beat rate checked in at 62.7% last quarter, which marked a huge increase from the previous quarter’s 48.2%. In the end, any reading above the long-term average of about 62% should prove to be another catalyst for higher stock prices.
Bottom line: Since stock prices ultimately follow earnings, the market has reached a critical test. We need companies to beat it! They need to put up better-than-expected sales and earnings numbers if there’s any chance of the market climbing higher from here.
Naturally, I’ll be monitoring the activity and providing information on any urgent developments. But you don’t have to rely on me for updates. Both Bespoke Investment Group and FactSet provide periodic updates as the earnings season unfolds.