How do you set the stage for stock prices to continue moving higher even as the United States continues to set new records for daily new confirmed cases of the novel coronavirus? It’s simple. You lower earnings expectations. Then, you watch corporate America beat those lowered expectations.
You see, Wall Street analysts are professional sandbaggers.
Buy-side analysts — those that work for firms that buy stocks or recommend buying stocks — are amazing at underestimating the true strength of a company’s revenue and earnings potential.
Sell-side analysts — those that work for firms that issue, or sell, stocks — are amazing at finding and emphasizing any little good piece of news about a company. This includes its revenue and earnings potential.
While both forms of sandbagging can have an impact on the stock market, we’re most interested in buy-side sandbagging at the moment.
So why do analysts do this? Why do they “sandbag” their estimates?
Buy-Side Analysts and ‘Sandbagging’ Earnings Estimates
It’s all about incentives. Analysts get paid to provide information. If the information they provide makes their clients happy, they will continue to get paid. If it doesn’t, they won’t.
Buy-side analysts know that clients who pay for and act on their insights are going to be much more forgiving of a recommendation with an earnings estimate that overperforms than they are of a recommendation that was too rosy and underperforms — or worse yet, costs the client money.
Quarter after quarter, analysts lower expectations on Wall Street. They cut their estimates in the run-up to earnings season, setting everyone up to be pleasantly surprised when the numbers come in “better than expected.” After all, it’s much easier to clear a lowered hurdle.
The amazing thing is that everybody knows this is happening. Yet it continues to work a surprising amount of the time.
At this point, you’re probably wondering how much sandbagging analysts are doing with the Covid-19 pandemic still plaguing the global economy.
Well, according to FactSet, analysts have dropped their second-quarter 2020 bottom-up earnings estimates for the S&P 500 by 37% in the run-up to this earnings season.
That’s a tremendous amount of sandbagging.
Now, we’re not saying it’s not justified. We know the global economy has been hit hard and is continuing to struggle to fully reopen. But we haven’t seen double-digit sandbagging anytime during the past five years — let alone 37%.
This means that even if companies fail to report stellar numbers, they still have an excellent chance of beating expectations. Those surprises could push stock prices even higher than they already are.
Bottom-Up and Top-Down Earnings Estimates
When estimating what the earnings per share (EPS) for the S&P 500 is going to be, analysts can use either a bottom-up or a top-down approach.
With the bottom-up approach, analysts look at the EPS estimates for each of the 500 companies in the index individually. Then, analysts combine them to generate an overall forecast for the index.
With the top-down approach, analysts look at the broader economy and forecasts for macroeconomic indicators. They consider forecasts for gross domestic product, inflation, interest rates and corporate tax rates. Then, analysts estimate how those forces are likely to impact corporate earnings.
We’re referring to bottom-up estimates because they are slightly easier to quantify, however, both approaches are susceptible to sandbagging.
The Bottom Line
As you can see in the report linked above, there are only two quarters over the past five years where analysts didn’t lower their bottom-up earnings estimates for the S&P 500.
And what has happened to the S&P 500 during that time? It’s gone on to form new all-time high after new all-time high.
If the same trend holds for this coming earnings season — which “officially” kicks off when the big banks start releasing their quarterly numbers on July 14 — we could see the S&P 500 make a push for 3,400.
Granted, these are unprecedented times. Investors are nervous and every earnings season brings incredible uncertainty to Wall Street.
But unprecedented doesn’t necessarily mean bearish.
John Jagerson & Wade Hansen are just two guys with a passion for helping investors gain confidence — and make bigger profits with options. In just 15 months, John & Wade achieved an amazing feat: 100 straight winners — making money on every single trade. If that sounds like a good strategy, go here to find out how they did it. John & Wade do not own the aforementioned securities.
