EC HH Earnings Magic Exposed

Following the end of each fiscal quarter, SEC registered corporations release their financial statements. Typically, investors and the media place a lot of importance on these results. Consequently, stock prices tend to rise or fall based on how the financial results compare to a consensus of estimates made by Wall Street analysts.

Since the beginning of the current quarter (10/1/2016), 76% of the 113 S&P 500 companies that have released earnings results have exceeded expectations. Like so many quarters before, many investors and media pundits are supporting the naïve conclusion that earnings are better than expected. Unfortunately, few investors are paying attention to the measurement tool, expected earnings, to gauge its usefulness as a measure of earnings quality. In this article we uncover the crafty game that Wall Street and corporate investor relations departments’ play to put a positive spin on earnings releases and at the same time give the impression that stock prices are cheap based on forward looking earnings expectations.

Miraculous Results

The graph below shows that actual aggregate earnings growth for the S&P 500 has exceeded the corresponding consensus final expectation for earnings growth without fail since at least the second quarter of 2012.  Not once has a quarter’s earnings (green bar) been lower than the most recent earnings expectation (red bar).

Final Earnings Expectations versus Actual Earnings

To comprehend how corporate earnings can regularly exceed respective expectations quarter after quarter, one must recognize how earnings forecasts are used to manipulate investor expectations. When one studies the trend of earnings forecasts from a year preceding the results to the weeks prior the results, one will notice two things. First, initial earnings forecasts, are crafted to tell a bullish long term story of strong earnings growth. Second, over the course of the ensuing year, the estimates are adjusted significantly downward to temper expectations and therefore make actual earnings that fall far short of the original forecast appear pleasantly surprising. 

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Disclosure: Opinions expressed herein are current opinions as of the date appearing in this material only and are subject to change without notice. Reasonable people may disagree about the opinions expressed herein. In the event any of the assumptions used herein do not prove to be true, results are likely to vary substantially. All investments entail risks. There is no guarantee that investment strategies will achieve the desired results under all market conditions and each investor should evaluate its ability to invest for a long term especially during periods of a market downturn. No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those discussed, if any.

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