Earnings Season Update: Proceed With Caution

Includes: AA
by: Lou Basenese

Nearly a month ago – when aluminum giant, Alcoa (NYSE: AA), officially kicked off earnings season – I shared two key metrics we should be focusing on: the earnings “beat rate”, and the guidance spread.

Now that roughly 70% of the companies in the S&P 500 have reported results, it’s time for a check-up before we head into the home stretch.

As you’ll see in a moment, there’s good reason to proceed with caution and pick your investments wisely.

Struggling to be average

Longtime readers are tired of me saying this, but it’s a proven fact that stock prices ultimately follow earnings. Or, more simply, as long as companies are producing more and more profits, stock prices are likely to charge higher.

That’s what makes the earnings beat rate – a measure of the percentage of companies beating analysts’ expectations for profits – such a useful indicator. It quickly tells us the financial health of the majority of the companies in the S&P 500 and the likelihood the index is going to head higher.

So what’s the latest reading telling us?

Well, at 61.5%, it’s not exactly an overwhelmingly bullish sign. Truth be told, it’s barely average. Since 1998, the historical beat rate averages out to 62%, according to Bespoke Investment Group.

A silver lining does exist, however. The beat rate is trending higher. Two weeks ago, it stood at a bull market low of just 57%.

But don’t get your hopes up too much. The strongest rallies occur when the beat rate tops 65%. Since more than half of the companies in the S&P 500 already reported results, it’s unlikely we’ll top that key threshold this quarter.

Don’t bet on the spread

As I noted last month, past results don’t matter as much as expectations for the future. Why? Because the stock market is a forward-looking animal. Which is where the guidance spread comes in.

It measures the difference between the percentage of companies raising guidance and the percentage of companies lowering guidance. A positive spread indicates that more companies are optimistic about the future. And a negative spread indicates that more companies are pessimistic.

The latest reading checks in at -3.3%, which means more companies are lowering guidance than raising it. More so than last quarter, too. In the third quarter the guidance spread checked-in at -2.1%.

Here again, a silver lining exists, as the guidance spread is improving. Last week, it stood at -4.2%. And it’s nowhere near the lows hit during the throes of the financial crisis at around -10%.

Choose wisely

So how should we interpret the less-than-inspiring results this earnings season? Simply put, we need to choose wisely.

Even though stocks are collectively cheap – trading for about 14 times earnings, on average – a rising tide is no longer going to lift all boats. Case in point: We haven’t experienced a single “all or nothing” day yet this year.

An “all or nothing” day is defined as a day when at least 400 stocks in the S&P 500 all move up or down in price. In 2011, we witnessed a record number of all or nothing days (70), with the majority occurring in the second half of the year. Six weeks into 2012, though, we haven’t experienced a single one. That’s a definitive change in trading behavior.

Bottom line: As I told you on Friday, we’re clearly in a stock picker’s market. And the latest earnings season stats underscore the need to choose wisely. I recommend you stick to companies reporting solid earnings growth and raising guidance for future quarters.