On the Spectacular Earnings Season

For my long-term investors there is nothing more important than corporate earnings, especially when compared to alternative investments.

Here are some key issues that I follow:

Forward or Backward?

I read hundreds of analyst reports and earnings call transcripts. Everyone is focused on future prospects in the analysis of specific stocks. In the market of stocks, everyone looks to the future. Somehow, when people try to evaluate the stock market, they prefer to look at the past. Why? It is pretty simple:

You can have solid, certain data that is not forward looking, or you can engage in forecasting. If your perspective is past earnings, ten-year earnings, past peak earnings, or whatever, you are rooted in what happened last year. By definition, you will miss what is happening right now.

Earnings Quality

The concept of earnings quality is important, mostly relating to the sustainability of apparent strength. While there are many challenges to quality, the 2009-era challenges relate to revenue. The idea is that corporations slashed costs and thereby exceeded earnings forecasts. From this viewpoint, earnings growth is not sustainable, since costs can only be cut so far. Without top-line growth, the earnings rebound will falter.

Defining Good News

This widespread challenge has everyone looking for a perfect earnings report: an earnings beat, revenue growth, and a positive outlook.

Will we see any of these? How many?

I did not expect much this quarter, since most companies are looking at the same data as the rest of us. Their corporate economists, if they even have one, are reviewing the modeling of other economists and reading the Wall Street Journal. Most importantly, in the post Sarbannes-Oxley environment there is a penalty for companies and accounting firms that engage in undue puffery. In fact, many companies no longer provide guidance.

Actual Data

There is an interesting historical pattern where most companies beat earnings expectations. Some critics take an interesting position, arguing both of the following:

• Forward earnings expectations are unduly inflated by optimistic companies and foolish analysts whose job is to sell stocks, and
• Companies beat expectations which have been driven down to a level that is easy to beat.

For both of these to be true, corporations must spin a positive picture a year out and then violently reduce estimates. This has not been happening. Forward earnings estimates have been growing at a solid pace.

The reports from this earnings season have been spectacular. Take a look at this informative chart from the fine team at Bespoke Investment Group.

If this does not grab your attention, you just do not care about data.

The Right Perspective

Much of Monday's pundit conversation was focused on the Fed. Many bearish market observers have taken the following path of analysis:

1. Expecting an economic collapse since the Fed had no options;
2. Criticizing the various innovative Fed strategies as unwise and predicting failure (first prediction wrong);
3. Denying economic progress under the Fed regime (second prediction wrong);
4. Renewing criticism of Bernanke and team as clueless and repeating mistakes;
5. Predicting some future failure, stagnation, or stagflation.

Whether these predictions prove to be correct on some multi-year time frame is an open question. Meanwhile, the immediate impact is hard to deny.

Personally, I look at a one-month time-frame in our TCA-ETF trading, where I update our position each week. For the average investor, I think a six-month to one-year perspective is more appropriate. When I look at data, I see continuing, gradual improvement in the economy and, more importantly in corporate earnings -- all in the face of a skeptical market. My initial target is the pre-Lehman (LEHMQ.PK) levels (both individual names and the market), where we need to take another look.

I outlined today's article during the day Monday, but the Apple Computer, Inc. (AAPL) and Texas Instruments (TXN) reports (after the close) underscore the Bespoke findings.

[Full disclosure: Regular readers know that my accounts are long AAPL and I have frequently recommended the stock for those needing a growth component.]

Comments

[enigmaman]

Jeff appreciate your sharing your thoughts about perspective, looking back as well as looking forward concerning earnings, etc. Today we have analysts saying things such as " based on historical whatever (PE, Earnings, PB etc) they make projections on companies going forward as if its business as usual. I wonder do they discount the recent past five years of these metrics because they were a result of a bubble and not a product real demand but just cheap easy money.In your article you do not address this matter of discounting unusual past history as it relates to stock analysis as well as taking into consideration the so called new normal going forward. It would seem logical for analyst to take these into consideration my question is are they when they

2009 Oct 20 08:11 AM

[CGP]

Interesting chart. Seems historically there are more net revisions down but note that after corrections it goes the other way. My takeaway is that the severe downturn has pushed all the forward estimates to be overly conservative/negative, a wall of worry to be climbed?

2009 Oct 20 12:39 PM