by Greg Harrison.
Every time the stock market makes another upward move, commentators nod their heads wisely and attribute the move to corporate earnings that are coming in at levels that are better than expected. Indeed, the first-quarter earnings season has been marked by companies announcing results that come in ahead of analysts’ forecasts. But those “positive surprises” may not completely reflect the reality of corporate earnings growth in the United States.
While a remarkable 72.4% of the companies in the S&P 500 that so far have reported their first-quarter results have beaten analysts’ expectations – a figure that, if it holds up to the end of earnings season, would be significantly higher than the long-term average of 62% – that good news masks a slightly more bearish reality. While corporate earnings are still growing, it is at a pace that is lower than that of the fourth quarter of 2011, and a less than half that recorded during the first quarter of 2011. And as for all of those positive surprises, they aren’t quite what they seem to be either, as analysts spent much of the first quarter cutting, slashing and trimming their earnings forecasts for the companies that they cover. So to the extent that those companies now are reporting “stronger than expected” earnings, it is just as likely to be because those expectations themselves have fallen as because the company has done better. Indeed, as the overall figures indicate, the average company in the S&P 500 is likely to have posted a more sluggish growth rate in the first quarter of 2012 than it did in the year-earlier period.
You don’t have to look any further than the S&P 500 itself for insight into this phenomenon. Back at the end of 2011, analysts expected that earnings for the companies in the index would grow slightly less than 6% in the first quarter of 2012. By late February, however, that forecast had nosedived to only 2%, and edged up only slightly, to just below 3%, by the time companies start announcing those results in mid-April. Faced with a lower hurdle, one company after another has announced a positive surprise and the growth estimate for the S&P 500 has recovered, although it still lingers below its 2011 year-end levels.
What has caused so many analysts to err so dramatically on the side of being bearish? After all, consensus forecasts are the aggregate of thousands upon thousands of individual forecasts of individual company results, not the opinions of a handful of individuals. As the chart below demonstrates, while the first quarter may end up being the most dramatic example of analysts setting lowball estimates for profits that companies easily exceed, it is far from the only period in the post-financial crisis market environment that analysts have made similar miscalculations. Since the beginning of 1994, there have only been 14 quarters in which 70% or more of companies in the S&P 500 have posted positive earnings surprises. Of those 14 periods, all but four have been recorded since the second quarter of 2009. Indeed, since then there have only been two quarters in which the rate of positive earnings surprises has fallen below 70% — a complete reversal of the trend.
While it’s impossible to state definitively what accounts for this phenomenon, it is reasonable to advance some hypothesis. The most obvious one, perhaps, is that it has become more difficult for analysts to gauge corporate earnings trends in the volatile and risky environment that has prevailed in the aftermath of the 2008 financial crisis. A bumpy and uneven economic recovery in the United States was hard enough to track, but given that the majority of S&P 500 companies do business globally and can expect to see everything from the eurozone crisis to the prospect of a hard economic landing in China affect their bottom lines, it has been harder than ever to track what headwinds might cause profit growth to stall. Throw market volatility into the mix, and analysts can be forgiven for being even more nervous about encouraging investors to expect high rates of earnings growth. Instead, what seems reasonable is to err far – sometimes very far – on the side of caution.
Compounding the problem is the fact that analysts historically have had more divergent views as the market becomes more volatile – just look at the post-crisis period in the chart below for evidence of this – in the last two years, they appear to have been “herding”. In other words, they appear reluctant to allow their individual estimates to vary too much from that of the crowd. That may be because there is too much uncertainty or because they believe there to be too much “career risk” should they end up with a reputation for over-estimating corporate earnings in the current market environment.
If the first quarter earnings season wraps up with a strong 72% of S&P 500 companies beating analysts’ earnings estimates, however, investors are likely to take a step back and ponder this state of affairs. How useful, they may wonder, are earnings estimates that so consistently and significantly understate real earnings growth rates, even when that earnings growth is only modest, in the low single digits?
Certainly, the trend drives home the importance of finding new ways to analyze analyst estimates, such as StarMine’s SmartEstimate scores, so that a positive earnings surprise comes as less of a shock. While an upside surprise can deliver an upward push to the stock price of the company reporting better-than-expected results, only those investors who have been prescient enough to position themselves beforehand will be able to profit from such a move.
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