Second-quarter earnings season wraps up this week. To hear the über-bulls talk, it's been an earnings-driven run in the S&P 500 for the last three years. But that is what's not happening with the S&P 500 this year. The market wants earnings to be "up, up, up" but they are "not, not, not."
As of last Friday, the estimate for S&P 500 earnings for 2014 stood at $119.91. As of the last reading in 2013, on December 27, the estimate for 2014 was $119.83. Yes, so with all the turmoil and almost all of three earnings seasons (4Q2013, 1Q2014, 2Q2014) done, the estimate has increased all of eight cents.
Is the lack of improvement due to pinpoint accuracy of state-of-the-art earnings forecasting? As a sell-side analyst for 10 years, I can tell you: we aren't that good. No one could be.
It's a game in which CFOs and analysts move the needle throughout the quarter and the final number always comes in a penny or two better. My background is in pure, fundamental research and it just drives me bananas when financial pundits say "earnings don't matter." Nothing could matter more than earnings. A company's earnings power is the determinant of its stock price, not the other way around.
But if earnings estimates never move, could the market be lulled into a state of complacency about the drivers of those earnings? Sure, and I believe that is happening now.
The game is the game. CFOs guide analysts to a "makeable" earnings number, and then beat that number on the Earnings per Share line. Record levels of corporate share buybacks obviously flatter the EPS comparisons. But hey, who's got time to dig through all those numbers? Honestly, a company beating by a couple of pennies is generally baked into the stock in the trading day or two before earnings are reported.
But, as an investor, what you are really looking for is the Holy Grail. The beat and raise. That is the gold standard: a company that not only beats estimates for the most recent quarter but increases guidance for the current quarter, and beyond.
I remember trading options in 2007 and the earnings momentum was coming from plays on infrastructure growth in the Middle East and China. E and C companies like Foster Wheeler (FWLT) and Fluor (FLR), shippers like DryShips (DRYS) and Eagle Bulk (EGLE), those were the companies that would consistently report earnings ahead of analyst expectations and guide analyst estimates higher for future periods. Heady stuff; it was just a matter of trying to figure out when the commodities super cycle would end.
The second quarter has--as all recent quarters have, that's the way the game works--exceeded expectations. Blended earnings growth now stands at 8.4%. That's up from the estimated figure at the beginning of the quarter, which was 6.8%.
But that's where the narrative and the numbers diverge. If we disaggregate the 2014 S&P 500 EPS estimate and just look at second half, the 2H2014 estimate is actually slightly lower now ($61.86) than it was on 12/27/2013 ($61.91.)
However, that does not fit the uber-bulls' narrative: the US economy is rocking back to life after the weather-induced swoon in the first quarter, and the stock market is the place to be as we watch second half economic growth exceed expectations.
If that narrative were true, though, wouldn't that necessarily show up in increased second-half profit expectations for the S&P 500? Of course it would; the earnings of the S&P 500 are an accurate proxy for corporate America's true earnings power.
But that's not what's happening here. As an analyst, if your earnings estimate for the year is an equally-weighted $1.00 and the first half comes in at $0.60, you have three choices:
- Raise estimates for the second half to (for example) match second half earnings power with the first's, which nets out to a new annual estimate of $1.20. That's the beat-and-raise.
- Leave your second half estimate alone and in process raise your earnings estimate for the year to $1.10. The wire services will pick up on this as increase in expectations even though it is not, but professional investors know the difference.
- Leave your annual earnings estimate at $1.00, which is a de facto lowering of second half earnings to $0.40 from $0.50.
What's happened with S&P 500 earnings estimates is a clear example of the third scenario, which obviously is the least bullish. Is there some gamesmanship -- managing of expectations -- in these low estimates? Of course.
But that's just some technical inside baseball, not at all suiting the über-bulls narrative of "things can only get better." When the numbers don't match the narrative, I worry. And when I worry, I keep my clients away from broad-based positions in blue-chip S&P 500 stocks.
