It’s widely accepted that earnings are the single most important determinant of a company’s stock price. Lots of factors enter the equation that determines the value of a company’s stock, but earnings—also known as profits and net income—literally constitute the bottom line.
With earnings data so important, it perhaps should come as no surprise that Wall Street analysts and company executives are playing a game with release of quarterly earnings data.
In a pattern repeated in each of the four quarters of 2012, analysts’ initial forecasts for corporate profits were revised downward every quarter. Company executives provide quarterly “guidance” to analysts, expressing skepticism about whether the company can meet expectations set in the previous quarter’s forecasts. Consequently, when the company announces its actual earnings, it delivers a “positive surprise” by exceeding the most recent forecast.
Please understand that nothing nefarious or evil is happening here. There is no conspiracy to mislead investors. It’s not deliberate. Rather, the gaming is caused unconsciously by Wall Street analysts reacting to corporate spin.
No one can say for sure if the pattern will continue in 2014. However, if it does continue, it could support expanding valuations on stocks in 2013—a possibility that deserves consideration. Here’s what’s happening:
In the chart above, the blue line represents forecasts by Wall Street analysts starting on July 1, 2011, for the first quarter of 2012. The source of the data is a survey of Wall Street analysts by Thomson Reuters that is used by many of the world’s largest investors to make informed decisions about company performance.
The blue line represents consensus estimates of analysts for earnings in 1Q2012 starting July 1, 2011, at more than $26 a share. As the first quarter of 2012 nears, analysts begin shaving their estimates. By the end of the first quarter of 2012, analysts had shaved their estimates to less than $24 per share.
In the second quarter of 2012, after the actual earnings for companies in the S&P 500 Index for the first quarter of 2012 are announced, the price of the S&P 500 pops up. Why? Because analysts have low-balled their expectations so much that the actual earnings announcement is a positive surprise for investors.
The same pattern occurred with earnings projections for each of the four quarters of 2012. Each quarter, analysts reduced their expected earnings and then the stock price popped on the announcement of actual earnings after the quarter was over.
One cause of the pattern is likely corporate spin. Each quarter, company CEOs and investment relations executives talk down expectations on company earnings. Public companies are permitted to offer earnings “guidance” to analysts. Both spin-masters and analysts would prefer to underestimate expectations and see positive surprises for exceeding expectations. That’s much better than being wrong because a company reporting disappointing earnings could suffer a stock plunge.
What’s it mean to individual investors? If the pattern holds, then earnings will continue to provide positive earnings surprises for America’s blue chip companies, those listed in the S&P 500. That provides good support for a bull market. But playing Wall Street’s game always involves risk. Though this pattern seems predictable, you never know. Past performance does not by any means guarantee what will happen in the future, and you don’t want to bet the ranch on this or any other market phenomenon. Still, it’s good to try to understand what’s really going on.