Earnings Collapse Coming Up; Don't Worry Companies Will Still 'Beat the Street'; Value Traps and Road to Ruin
Of all the inept reasons to be bullish about equities, "beat the street" hype is near the top of the list. The fact is, in aggregate, ever since Reg-FD (full disclosure) companies always beat the street.
In Surprising Optimism in Face of Weekly Global Equity Carnage; Foolish Comments of the Day; "Beat the Street" Bullsweet I noted nearly every quarter, even in 2008 and 2009 the majority of firms beat estimates. Here is the way the process works:
- Corporations give analysts "tips" regarding profit expectations.
- Those profit expectations are purposely low.
- Wall Street analysts lower estimates, if necessary, as the quarter progresses such that corporations can "beat the street".
- If corporations are going to miss and need an extra penny, they change tax assumption or make other "one time" adjustments as necessary.
- Corporations beat the street by a penny with "pro-forma" (after adjustment) reporting.
Understandings Earnings Estimates
A couple of readers asked for a historic chart of "beat the street" metrics
I just happen to have one, with thanks to Understandings Earnings Estimates by James Bianco on the Big Picture Blog.
Aggregate S&P 500 earnings have beaten expectations for 50 straight quarters, including the current quarter. As we explained last July:
The chart below highlights the inception of SEC regulation "FD" (aka, Fair Disclosure). Before FD roughly 50% of companies beat expectations, as would be the case if analysts were trying to get it right. Now that companies have to disclose to all at the same time, we believe their investor relations departments are masters at "guiding" analysts just below actual earnings.
This way the companies "beat" expectations and get the positive press and accolades that come with it. Further, it seems that everyone is happy with this apparent gaming of the system. This is why we believe the percentage of companies that beat expectations is a meaningless statistic. The game is designed for this to happen, even when earnings are collapsing (during 2008's epic collapse in earnings more than 50% of companies still beat expectations).
Percentage of Companies that "Beat the Street"
The last time companies failed to "beat the street" was third quarter of 1998. At the earnings trough in third quarter of 2008, 58% of companies in the S&P 500 still managed to "beat the street".
Sentiment, Not Earnings Key to Returns
If this "beat the street" talk was not pathetic enough in and of itself, the fact remains that sentiment, not earnings, is the key to stock market performance.
I discussed this concept at length in a pair of posts earlier this year.
- Negative Annualized Stock Market Returns for the Next 10 Years or Longer? It's Far More Likely Than You Think
- Anatomy of Bubbles; Negative Returns for a Decade Revisited; Is Gold in a Bubble?
Please read those posts if you have not yet had a chance to do so.
On June 20, in Value Traps Galore (Including Financials and Berkshire); Dead Money for a Decade I noted Berkshire, Citigroup, and Bank of America were "value traps".
At that time Citigroup had a price-to-book valuation of .64, and Bank of America a price-to-book valuation of .50.
Those who thought Bank of America was cheap at book value, now find themselves 62% in the hole. I suspect they may still be in the hole 10 years from now.
Stocks that look cheap can always look cheaper.
Road to Ruin
John Hussman repeats his recession and valuation warnings in Two One-Way Lanes on the Road to Ruin
It is important to recognize that the S&P 500 is presently only about 13% below its April peak, and the word "only" deserves emphasis. Our valuation impressions align fairly well with those of Jeremy Grantham at GMO, who puts fair value for the S&P 500 "no higher than 950" - a level that we would still associate with prospective 10-year total returns of only about 8% annually. I would consider investors to be very fortunate if the market does not substantially breach that level in the coming 12-18 months.
Wall Street continues its servile attachment to forward operating earnings, seemingly unconscious that the perceived "norms" for the resulting P/E are artifacts of a bubble period. The fact is that historical periods of overvaluation and poor subsequent long-term returns correspond to forward operating P/E multiples anywhere above 12, while secular buying opportunities such as 1950, 1974 and 1982 map to forward operating multiples of only 5 or 6 (based on the strong correlation but downward-biased level of forward operating P/E ratios, when compared with multiples based on normalized earnings - see Chutes and Ladders for a graphic).
Without question, one of the notions buoying Wall Street optimism here is the hope that the Fed will pull another rabbit out of its hat by initiating QE3. That's a nice sentiment, but it does overlook one minor detail. QE2 didn't work.
Actually, that's not quite fair. The Federal Reserve was indeed successful at provoking a speculative frenzy in the financial markets, which has now been completely wiped out. The Fed was also successful in leveraging its balance sheet by more than 55-to-1 (more than Bear Stearns, Lehman, Fannie Mae, Freddie Mac, or even Long-Term Capital Management ever achieved), and driving the monetary base to more than 18 cents for every dollar of GDP. The Fed was indeed successful in provoking a wave of commodity hoarding that affected global supplies and injured the poorest of the poor - particularly in developing countries. The Fed was successful in setting off a very predictable decline in the value of the U.S. dollar. The Fed was successful in punishing savers and the risk averse, and driving investors to reach for yield in risky investments that they would normally avoid were it not for the absence of yield. The Fed was successful in provoking those with strong balance sheets to pay down existing higher interest-rate debt, and in creating an incentive for those with weak balance sheets to issue more of it at low rates, resulting in a simultaneous deterioration of credit quality and compensation for risk in the financial system.
Hussman's article is well worth a read in entirety.
In terms of expected annualized returns, I think Hussman is a bit too optimistic over the long-term even though I endorse his intermediate-term philosophy "I would consider investors to be very fortunate if the market does not substantially breach [S&P 950] in the coming 12-18 months."
Speaking of optimistic, way too optimistic ...
Strategists Stick With 17% S&P 500 Gains Based on Earnings
I am amused at the amazing year-end projections of strategists as noted in Strategists Sticking With 17% S&P 500 Gain on Higher Profit
Wall Street has never been more sure that the Standard & Poor's 500 Index will rally in 2011, even after speculation the U.S. economy is heading for a recession prompted the biggest plunge since the bull market began.
Strategists say earnings growth will fuel gains. S&P 500 profit will rise 18 percent in 2011 and 14 percent in 2012, according to the average per-share analyst estimates in a Bloomberg survey. More than 75 percent of corporations in the index have exceeded earnings estimates for the second quarter, with total income topping projections by 5.2 percent.
- Tobias Levkovich, Citigroup Inc. (C)'s chief U.S. equity strategist in New York, forecasts the S&P 500 will end the year at 1,400.
- Brian Belski, the New York-based chief investment strategist at Oppenheimer & Co., estimates the S&P 500 will reach 1,325.
- Barry Knapp, the New York-based chief U.S. equity strategist at Barclays year-end projection is 1,450.
- Credit Suisse Group AG (CSGN) and HSBC Holdings Plc (HSBA) advised investors to buy equities today. Andrew Garthwaite, a London- based strategist at Credit Suisse, reiterated an "overweight" recommendation on stocks even as he cut his year-end forecast for the S&P 500 to 1,350.
Corporate Earnings Set to Plunge
Nearly anything is conceivable, but I think fiscal and monetary stimulus has run its course and earnings will plunge.
The Eurozone is heading for a recession or in one. China is slowing. The UK is in recession or headed for one, Australia and Canada, same story.
In spite of denial by analysts, the US is on a recession track if not in one.
Moreover, judging from the unemployment rate, corporations are running pretty lean here. If profits plunge, it will be tough to cut a lot of employees to make up for revenue shortfalls.
Implications are severe either way. One affects job, the other earnings. The US can easily take a hit both ways.
Telling Action in Bank Shares
Take a look at the action in bank shares. They tell the story of excess leverage and capital shortfalls. On July 18, 2011 Bank of America Clobbered on $50 Billion Capital Shortfall Related to Mortgage Losses
Capital shortfalls are not unique to Bank of America. For the current sorry state of affairs of the banking system, please see BNP Paribas leveraged 27:1; Société Générale Leveraged 50:1; Global Financial System is Bankrupt.
With this backdrop, I fail to see how earnings can't plunge. But hey, look on the bright side: companies will still "beat the street". They always do.