The Truth About First-Quarter Earnings

Includes: AA
by: Lou Basenese

Last Tuesday, Alcoa (NYSE: AA) officially kicked off the first-quarter earnings season.

After missing earnings expectations for three consecutive quarters, the company was a shoe-in to miss expectations again, right? Wrong!

Alcoa ended up beating Wall Street analysts’ best guesses by a country mile. It reported a profit of $0.09 per share versus expectations of a loss of $0.04 per share. Not surprisingly, shares rallied 8% on the news, amounting to the best single-day gain in four months for the economic bellwether.

Was Alcoa’s report a fluke sign of strength? Or is it something we should expect more of in the weeks ahead? I’ll be answering those exact questions today. And like I do every quarter, I’ll be looking at the three key metrics we should be focusing on as this earnings season unfolds.

Not So Great Expectations

There’s a myth flying around Wall Street that earnings expectations are so low this quarter that companies should have no trouble topping them.

Even The Wall Street Journal is in on the act…

In a recent article, “Earnings Season: Companies Have Low Bar to Hurdle”, the financial paper of record quotes Nicholas Colas, Chief Market Strategist at ConvergEx Group, saying, “Corporate America has a very low bar to cross in order to impress analysts and investors.”

The disparity between Alcoa’s results and analysts’ expectations only reinforces this myth. Likewise for JPMorgan Chase (NYSE: JPM). The banking giant also topped profit expectations by a margin of $0.13.

Don’t be fooled by all of this. Because the truth is, expectations aren’t so low after all.

While consensus estimates for profit growth for the S&P 500 Index is only about 2% this quarter – which is low compared to recent quarters – expectations are actually increasing. And that’s an uncommon occurrence heading into earnings season.

Typically, analysts lower their expectations in the four weeks preceding earnings reporting season. But instead of tempering their bullishness this quarter, they’re increasing it.

As Bespoke Investment Group reports, the net revisions ratio for the S&P 1500 Index has increased from -4% to +7.5% in the last four weeks. (A negative reading means analysts cut expectations on more companies than they raised forecasts on, and vice versa for a positive reading.)

“This is far and away the largest increase in this indicator in the month leading up to an earnings season since 2008,” says Bespoke.

Of course, we’re still early in the reporting season. Only about 4% of the companies in the S&P 500 have reported results so far. But the activity is really about to heat up. Next week a total of 758 companies are scheduled to report results.

If the trend of beating expectations continues, we shouldn’t downplay it like every other financial pundit suggests. Instead, we should embrace it.

You see, when earnings come in strong, stocks historically rally. Take last quarter, for example. On the heels of solid profit growth in the face of a slowdown in Europe, the S&P 500 Index rallied 6.36%. It was the fifth best earnings season return for the Index over the last 10 years.

Based on the prevailing sentiment this quarter, the stage is certainly set for another historic rally. With that in mind, here are three key metrics we should be tracking…

Key Statistic #1: Earnings “Beat Rate”

No doubt, longtime readers are tired of me saying this. But it’s a proven fact that stock prices ultimately follow earnings. 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.

The historical average earnings beat rate is 62%. So any number above that would be a bullish sign for the stock market. Of course, the strongest rallies tend to occur when the beat rate tops 65%. But that’s not a hard and fast rule.

Remember, last quarter the S&P 500 logged its fifth best earnings season gain and yet the earnings beat rate was only 60.4%. Ultimately, anything above 60% should propel the stock market higher this quarter.

If you want to focus on specific sectors, stick to Technology and Consumer Discretionary stocks. Earnings beat rates for the sectors checked-in at 68.2% and 65.7%, respectively, last quarter.

Outperformance in these two sectors is to be expected at this stage of an economic recovery. And it’s likely to continue, too, as consumers and businesses regain confidence and, in turn, spend more.

The fact that the International Monetary Fund raised its global growth forecast yesterday for the first time in more than a year – based on improving conditions in the United States – only strengthens the investment case for these cyclical sectors.

Key Statistic #2: Revenue “Beat Rate”

Revenue figures can’t be faked or massaged like earnings. As a result, they represent the surest sign that demand for goods and services is increasing. And the easiest way to track demand trends is to track the revenue “beat rate” – the percentage of companies beating analyst expectations for sales.

Last quarter, only 56.7% of companies beat revenue estimates. That’s below the historical average of 62%.

This quarter, anything above 60% would support higher stock prices. And a reading above 65% would be extremely bullish.

Key Statistic #3: Guidance Spread

Since the stock market is a forward-looking beast, past results don’t matter as much as expectations for the future. That’s where the guidance spread – the difference between the percentage of companies raising guidance and the percentage of companies lowering guidance – comes in.

A positive spread indicates that more companies are optimistic about the future. And a negative spread indicates that more companies are pessimistic.

As a frame of reference, the guidance spread has ranged from -2.4% (4Q 2011) to 5.2% (4Q 2009) since the current bull market began. So any positive reading should be considered bullish. Especially since the guidance spread for the last two quarters was negative.

Bottom line: Again, don’t buy in to the myth that expectations for this earnings season are so low that they’re meaningless. Instead, remember that analysts’ bullishness is actually up and if earnings continue to shine, there’s a great chance we’re in for a healthy rally. In the meantime, keep from being led astray by following those key metrics.