October 14th, 2012
by Jeff Miller
Earnings season follows a familiar, four-step pattern:
- Preliminary -- Analyst estimates are too optimistic, perhaps because they "go native."
- Confession -- Adjustment and warnings as companies "pre-announce," usually when the report will be a disappointment.
- Announcement -- Actual results with explanations and outlook for the future. There is an initial market reaction to the news.
- Interpretation and Spin -- The company does a conference call where analysts either congratulate management or ask probing questions. The stock usually keeps trading during the conference call, and often provides a real-time interpretation of the management discussion.
It is often not easy to interpret. The conventional wisdom is that analysts are too bullish on earnings estimates and also set the bar too low for the actual report. Most seem not to notice that these are contradictory positions.
Rather than starting from scratch on this subject, I recommend that readers take another look at something I wrote more than two years ago. I explained one of our regular themes at "A Dash." Most of the punditry uses words rather than data. The key point is that the earnings story is complicated, which provides many opportunities for spinning.
"Instead, there is a long laundry list of tests:
- Earnings -- comps from last year.
- Earnings -- meeting expectations.
- Earnings -- meeting the "whisper number."
- Revenues -- should meet all of the above. The market is very skeptical of earnings from cost-cutting, even though that shows smart management and can easily be reversed. It is a clear-cut bias.
- Gross margins falling -- another thing that can be wrong. Even though it might be correct to compete by cutting margins, the pundits will pounce.
- Gross margins rising -- evidence of unsustainable earnings on a long-term basis.
- Foreign sales -- another no-win area for management. If you suggest that sales were lower, then pundits will infer Europe weakness. If you try to cite currency changes, you get the opposite spin.
- Ignore current earnings. Look backward.
- Ignore forward earnings. Look backward.
- Ignore strong earnings. Look at multiple year growth estimates.
- Ignore long-term growth estimates. Those are too bullish.
The added complexity of the earnings story is not helpful to the investor. For consideration by investors who want to look more deeply into this process, I now posit "The Miller Rule."
The more variables, the more spin potential."
Even those who are accurate in forecasting actual earnings may be losers in the short run based upon this list. I'll offer my own take in the conclusion, but first let us do our regular review of last week's news.
Background on "Weighing the Week Ahead"
There are many good lists of upcoming events. One source I especially like is the weekly post from the WSJ's Market Beat blog. There is a nice combination of data, speeches, and earnings reports.
In contrast, I highlight a smaller group of events. My theme is an expert guess about what we will be watching on TV and reading in the mainstream media. It is a focus on what I think is important for my trading and client portfolios.
This is unlike my other articles at "A Dash" where I develop a focused, logical argument with supporting data on a single theme. Here I am simply sharing my conclusions. Sometimes these are topics that I have already written about, and others are on my agenda. I am putting the news in context.
Readers often disagree with my conclusions. Do not be bashful. Join in and comment about what we should expect in the days ahead. This weekly piece emphasizes my opinions about what is really important and how to put the news in context. I have had great success with my approach, but feel free to disagree. That is what makes a market!
Last Week's Data
Each week I break down events into good and bad. Often there is "ugly" and on rare occasion something really good. My working definition of "good" has two components:
- The news is market-friendly. Our personal policy preferences are not relevant for this test. And especially -- no politics.
- It is better than expectations.
The news last week was mostly positive, including these highlights.
- The dollar death cross has triggered! For more than a year the dollar has been inversely correlated with stock prices, so this technical indicator is bearish for the dollar and bullish for stocks. See Min Zing in the WSJ for a full account.
- Romney pulls even among likely voters according to the Pew Research Center, among others. (Please note the above definition of good=market-friendly. We are not cheering for either candidate. We are analyzing the implications for investments. Right or wrong, the market likes Romney). The effect did not last for even a day, however, perhaps because of some tortured logic about Romney firing Bernanke, whose term ends in January, 2014. Sites analyzing the Electoral College result still show Obama in the lead.
- Initial jobless claims dropped dramatically. This sparked more silliness about manipulation of the data. The seasonal adjustments can be tricky at this time of year, which is why we emphasize the four-week moving average. Hats off to Invictus and Barry Ritholtz (see here as well) for helping everyone keep focus on this issue. Here is a helpful chart from Calculated Risk:
- Michigan consumer sentiment spiked almost to pre-recession levels. This report deserves more respect. It is an excellent concurrent indicator, but reflecting several factors. In the last year or so the spike in gas prices and the political shenanigans have polluted the results. Normally this is a good indication of employment and consumption. For it to increase at a time when gas prices are elevated and the political silly season is in full swing is very positive for employment. Here is Doug Short's excellent chart, my favorite for this series:
We are almost back to normal levels.
The actual data last week was pretty good, but the stock result was bad. This happens, and it can be meaningful. Let us take a closer look.
- The world economy is weakening with the threat of a double-dip recession according to new reports from the IMF and Brookings. (via the FT).
- Insider selling sends a warning (via Mark Hulbert). I am a big fan of Mark Hulbert, but I am a little uncomfortable with this article. There are always reasons for insiders to sell, since the stock and options are part of a compensation package. (I am the chair of the comp committee for a small public company). It is also natural that selling is higher when the stock price is higher. Insider buying is a much better indicator than selling. But we should watch all indicators, so I advance this for discussion.
- The Fed Beige Book suggests only modest growth. Steven Hansen at GEI reports. His research provides an interesting compendium of Fed comments before the last two recessions, which have an eerily similar quality.
- Gasoline prices threaten the consumer. The Bonddad Blog tracks this and many other high-frequency indicators (some of which are positive). You really need to follow the complete weekly article -- just as I do:)
- The early reaction to earnings. We will know a lot more about this next week, but the early indication is intense skepticism. There seems to be a negative tone.
- Small business reactions and forecasts remain negative, especially from the highly partisan National Federation of Independent Businesses (NFIB). Here is a nice account from GEI, and a chart from Doug Short:
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