Q3 Earnings Preview

Earnings estimates are low … which means they’re easy to beat … this should help support the market over the coming weeks …

 

Q3 earnings season kicks off today, and stocks are likely headed higher.

The reason behind it?

Positive earnings surprises.

Now, at first glance, this seems like a tall order.

FactSet, which is the go-to data analytics company the pros use for earnings estimates, is estimating a year-over-year earnings-decline for the S&P of -20.5%.

If that happens, it will be the second largest earnings decline since Q2 2009 (-26.9%).

So, where’s the optimism coming from?

Well, in short, Wall Street is incentivized to sandbag earnings. Especially in an uncertain economic environment like we have right now.

And if analysts are setting low earnings hurdles, that creates the right environment for a wave of positive earnings-surprises, which drives markets in the short-term.

Now, let’s make sure we’re on the same page about this “driving markets” point before we move on.

If we look at what drives stocks up or down over the long-term, we’d point toward earnings. And not just earnings at one point in time. Rather, how they’re coming in over a period of quarters. As well as whether they’re rising or falling based on core business growth.

From this perspective, yes, bubbles will form when a stock price gets way ahead of a company’s actual earnings numbers (the opposite can be true as well when a stock price is unduly punished). But over the long-term, a stock price will generally rise or fall to reflect the condition of a company’s earnings.

But in the short-term, something else pushes a stock around …

Surprises to earnings expectations.


***The most significant influence on short-term market prices is the difference between what was expected to happen and how things actually played out

 

To illustrate, let’s look at a company’s earnings report.

If analysts are calling for $10/share of earnings, but that number comes in at $8/share, that massive 20% miss is going to take the market by surprise. Expect a sell-off.

However, let’s say analysts were expecting a loss of $3/share, but that number came in at a loss of just $2/share. This time, the surprise was positive. The stock will probably surge.

But notice the nature of these “events” themselves — the first company profited $8/share yet its stock collapsed. Meanwhile, the second company burned through $2/share, yet its stock rose.

In a vacuum, this makes little sense. But it makes perfect sense when viewed through the lens of expectations.

Market events themselves aren’t the driver of short-term prices — it’s surprises to our expectations.

And as we stand today, Wall Street is setting us up for some positive surprises.


***The case for more market gains thanks to “sandbagged” Q3 earnings estimates

 

The way to boost stock prices, even with coronavirus cases ticking up … even with employment numbers running into headwinds … even with the economy not fully open … is to lower the bar.

It’s that simple.

And the reality is that Wall Street analysts are professional sandbaggers.

Our technical experts, and editors behind Strategic Trader, John Jagerson and Wade Hansen, wrote about this reality as we entered Q2 earnings season a few months ago:

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 and its revenue and earnings potential.

So, why would analysts intentionally sandbag the numbers?

The answer boils down to incentives.

Analysts get paid to provide information.

If the information they provide makes their clients happy, they continue to get paid. If that information makes their clients unhappy, watch out.

Buy-side analysts know that clients who pay for their insights are going to be much more forgiving of a recommendation that overperforms an earnings-estimate than they would be an estimate that sets up a disappointment, resulting in a price selloff.

Back to John and Wade:

Quarter after quarter, analysts lower expectations on Wall Street by cutting 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.


***The numbers behind the sandbagging

 

Let’s put some actual numbers on these underestimates so you can see for yourself.

As we noted earlier, FactSet is the go-to data analytics company for earnings estimates.

Below we present a chart from FactSet. It shows earnings estimates in gray, alongside real earnings in blue, dating back to Q4 2017.

What you’re going to find is that over a span of 11 quarters, estimates came in beneath actual results 10 times.

And what about the lone instance in which earnings were worse than estimates?

That was Q1 of this year, when the pandemic took the world by surprise, which analysts obviously didn’t see coming.

 

 

By the way, be sure to notice Q2 of this year.

Analysts were so terrified of the impact of lockdowns on the economy that their estimate for the S&P 500 was -44.1%. Earnings came in -31.6%.

While -31.6% is an astonishing loss, it’s still only about 70% of the damage that analysts called for. That’s a ton of room for earnings to be terrible — yet still come in better than expected.

But that’s how this game works. Set the bar low, beat estimates, investors applaud, and markets rise.

Here’s FactSet putting numbers on the scope of the repeat-underestimating:

Over the past five years on average, actual earnings reported by S&P 500 companies have exceeded estimated earnings by 5.6%.

During this same period, 73% of companies in the S&P 500 have reported actual EPS above the mean EPS estimate on average.

As a result, from the end of the quarter through the end of the earnings season, the earnings growth rate has typically increased by 3.4 percentage points on average (over the past 5 years) due to the number and magnitude of positive earnings surprises.

Given this, we should take earnings estimates with a grain of salt.

Yes, they are down year-over-year … but odds are, the real numbers will come in better than expected — although that itself should be expected.

It’s started Tuesday morning as I write, with Citigroup, JPMorgan, Johnson & Johnson, and Blackrock topping earnings estimates.


***The added benefit of earnings coming in higher than forecast

 

As we noted at the top of this Digest, temporary bubbles form in stock prices when investors bid up prices well beyond what actual earnings warrant.

As we stand today, market prices relative to today’s earnings are high. Labeling them “bubble” is debatable, but they’re well above average.

We measure this by evaluating the market’s price-to-earnings ratio. In other words, what are we paying today, for how earnings have come in over recent quarters.

But using yesterday’s earnings comes with a big drawback. Namely they’re already old-news. They reflect earnings (or losses) that have already happened. And Wall Street focuses on “forward” not behind.

To better reflect Wall Street’s forward-orientation, we can take the same price-to-earnings ratio, and simply substitute in forward earnings estimates — the same ones that analysts are sandbagging.

Here too, valuations are high today.

From FactSet:

The forward 12-month P/E ratio is 21.9. This P/E ratio is above the 5-year average of 17.2 and above the 10-year average of 15.5.

It is also above the forward 12-month P/E ratio of 21.5 recorded at the end of the third quarter (September 30).

But if the earnings numbers that are used in the calculations end up coming in higher than expected, that’s going to take pressure off this lofty valuation level.

That should make investors who are in the market feel better about remaining in the market … and it could lure investors on the sidelines back into the market given more reasonable valuations.

Regardless of how that plays out, what we know is that Wall Street has a history of sandbagging earnings estimates. And that bodes well for the market over this Q3 earnings season.


***Before we wrap up, let’s point toward the real thing to watch

 

As mentioned earlier, over the long-term, earnings are what drives market prices.

The real issue to keep your eye on is whether U.S. states begin locking down their economies again if/when coronavirus cases tick higher in the colder months.

If that happens, and it severely impacts earnings, that’s when the market will run into real headwinds.

So far, Wall Street has been willing to overlook lower earnings based on the belief that a re-opened economy will mean normal-to-great numbers tomorrow.

But if the winter brings an economy saddled by lockdowns, which drag on earnings — not to mention a new wave of layoffs that hurts the American consumer — then Wall Street may be forced to stop looking out in the distance, and deal with the challenges of “now.”

Let’s hope that vaccine comes sooner than later and prevents that.

We’ll continue to keep you updated.

Have a good evening,

Jeff Remsburg


Article printed from InvestorPlace Media, https://investorplace.com/2020/10/q3-earnings-preview/.

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