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Friday, March 27, 2015 3:17 PM

Earnings "Beat the Street" Manipulation Underway as Profit Warnings Mount

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Of S&P 500 companies providing first-quarter outlooks, MarketWatch reports 84% have been negative as Profit Warnings Pile Up.

Ahead of the start of earnings reporting season, which unofficially kicks off when Alcoa Inc., reports results on April 8, about 84% of the companies that have provided first-quarter outlooks gave negative outlooks. That’s above the 81% that warned Q1 2014, and the five-year average of 68%.

I believe that yellow highlight I added should say Q3. More importantly, it would have been nice for MarketWatch to actually link to FactSet because it contains some interesting charts and analysis.

Earnings Insight

Let's dive into the FactSet Earnings Insight Report for first quarter of 2015.

Key Metrics

  • Earnings Growth: For Q115, year-over-year earnings for the S&P 500 are projected to decline by 4.6%. If the index reports a year-over-year decline for the quarter, it will be the first time since Q 3 2012 (-1.0%).
  • Earnings Revisions: On December 31, the estimated earnings growth rate for Q1 2015 was 4.2%. All ten sectors have lower growth rates today (compared to December 31) due to downward revisions to earnings estimates, led by the Energy sector.
  • Earnings Guidance: For Q1 2015, 85 companies have issued negative EPS guidance and 16 companies have issued positive EPS guidance.
  • Valuation: The current 12-month forward P/E ratio is 16.7. This P/E ratio is above the 5-year (13.7) average and the 10-year (14.1) average for the index.
  • Earnings Scorecard: Of the 16 companies that have reported earnings to date for Q1 2015, 14 have reported earnings above the mean estimate and 10 have reported sales above the mean estimate.

Earnings vs. Price

Q1 2015 Earnings Season: By the Numbers Overview

Analysts and corporations continue to lower expectations for earnings for the S&P 500 for the first quarter. On a per-share basis, estimated earnings for the first quarter have fallen by 8.2% since December 31. This is the largest decline in the bottom-up EPS estimate for a quarter since Q1 2009.

Companies have also lowered the bar for earnings fo r Q1, as 85 companies in the index have issued negative EPS guidance, while just 16 companies have issued positive EPS guidance. The percentage of companies issuing negative EPS guidance is 84% (85 out of 101), which is well above the 5-year average of 68%. As a result of the downward revisions to earnings estimates, the estimated year-over-year earnings decline for Q1 2015 is -4.6% today, down from an expectation of growth of 4.2% at the start of the quarter (December 31).
There is much more in the report. Inquiring minds may want to take a look.

Earnings Manipulation Underway

In spite of these downgrades (rather, because of these downgrades), when actual earnings are announced, expect a huge majority of companies to "beat the street".

Every year, whether earnings are going up or down, companies guide analysts to numbers low enough they can beat.

Don't Be Fooled

Please consider this CNBC report from April of 2014: Companies are Beating Earnings Estimates But Don’t Be Fooled.
Of the 85 S&P companies that have already reported their first-quarter earnings, 67 percent have beaten analyst estimates on the earnings side, and 51 percent have beaten on the revenue side, according to FactSet. That sounds pretty good—until one considers that over the past four years, 73 percent of companies have tended to beat earnings estimates, and 58 percent have tended to beat revenue estimates.
As with MarketWatch, CNBC did not have the decency to link to FactSet either.

Failure to 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".

Don't Worry Companies Will Still "Beat the Street"

In spite of those downgrades, history suggests corporations will still "Beat the Street".

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.

Mind the Gap

By the way, that's one hell of a gap between earnings guidance and stock price. The 10-year smoothed PE at the end of this earnings season is set to soar. The 10-year PE is already one of the three most expensive in history.

Doug Short at Advisor Perspective takes a look at the 10-Year PE in his March 2, 2015 post Is the Stock Market Cheap?

Stock are only cheap compared to 1929, the dot-com bubble, and the housing bubble. Given the plunge in earnings estimates, this market will soon pass the housing bubble in amplitude.

The 1929 peak may even be in sight. And in many ways, this bubble is worse than the dot-com bubble, as during the tech wreck one could find many companies with good valuations. It was predominately technology with PE extremes.

Doug Short notes ...
The historic P/E10 average is 16.6. After dropping to 13.3 in March 2009, the ratio rebounded to an interim high of 23.5 in February of 2011 and then hovered in the 20-to-21 range. The latest ratio is at a new interim high -- the highest since December 2007.

A cautionary observation is that when the P/E10 has fallen from the top to the second quintile, it has eventually declined to the lowest quintile and bottomed in single digits. Based on the latest 10-year earnings average, to reach a P/E10 in the high single digits would require an S&P 500 price decline below 550. Of course, a happier alternative would be for corporate earnings to continue their strong and prolonged surge.
Equities and junk bonds globally are now in massive bubbles. Nonetheless, expect analysts to focus on the number of companies that "beat the street" because that is one of the key ways they use to convince you "stocks are cheap".

Mike "Mish" Shedlock

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