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Earnings surprises are a signal in virtually all momentum systems. Unfortunately, earnings surprises give false signals when earnings quality is low, or when "surprises" are due to low-ball guidance. Both of these factors are at work in the second quarter, as the data below demonstrate.

EPS Hit, Sales Miss

Seeking Alpha contributor J. Clinton Hill has a very useful table on his Hillbent website: The Daily Earnings Surprise Summary. As you'd expect, it ranks the daily earnings surprises from best to worst, and it also shows reported sales vs. expectations. 62% of the 145 firms that reported results yesterday, for example, had positive earnings surprises. Only 32%, however, reported positive sales surprises (the data pool is smaller, since only 87 firms had sales estimates). Overall, earnings met expectations, but sales fell short.

Negative and Positive Sales Surprises

The list below shows firms that had double-digit sales shortfalls (revenues came in at least 10% below expectations):

  1. -33% Sunoco Logistic (SXL)
  2. -17% Commerical Vehicle (CVGI)
  3. -17% Westell Tech (WSTL)
  4. -16% Platinum Underwriters (PTP)
  5. -13% CH Robinson Worldwide (CHRW)
  6. -11% Peabody Energy (BTU)
  7. -11% Cemex (CX)

The following firms had double-digit positive surprises (revenues beat expectations by 10% or more):

  1. +41% Mueller Industries (MLI)
  2. +32% Yahoo! (YHOO)
  3. + 30% Jeffries Group (JEF)
  4. + 19% Advanced Micro Devices (AMD)
  5. + 14% Dr. Reddy's (RDY)

The Current Rally Reflects Naive Momentum Models

In March we had a reflation rally, as monetary and fiscal stimulus prevented a complete market meltdown, and as investors spotted some green shoots. Since July 13, positive earnings surprises have driven stocks higher. This has made it a frustrating earnings season for me: I've been right about the fundamentals (strong earnings, weak sales), but wrong about the market reaction (bullish, since investors focused on EPS, not sales). Positive earnings surprises are generating lots of bullish signals for momentum models, and this is driving stocks higher.

At this stage in the cycle, corporate earnings leverage is driven by cost-cutting, which generates "surprises," but makes for lousy earnings quality. (I guess positive earnings surprises are easy when you fire 10% of your work force.) Looking ahead, this rally sets us up for disappointment, since a company cannot "shrink its way to prosperity."

Disclosure: No positions in securities mentioned.

Source: Earnings Hit, Sales Miss: When Momentum Models Go Astray