Earnings Reactions Skewed Heavily To Downside Currently

Here's proof that investors are wising up to Wall Street's earnings game
When a company's earnings have beaten expectations, the stock has barely risen

by Mark Hulbert

Investors are finally wising up to the game companies play as they try to manage Wall Street’s expectations.

What those companies are trying to do, of course, is report that they have beat the consensus of Wall Street analysts’ earnings estimates. That’s a tall order, since it requires them to keep those expectations artificially low over the three months prior to earnings season.

While you might think this is perhaps possible for one or two quarters, it’s hard to imagine them getting away with it quarter after quarter. Wouldn’t Wall Street analysts—who presumably are quite intelligent—eventually catch on to the game?

Believe it or not, however, it appears as though either companies have become more skilled at playing this game over the years, or Wall Street analysts have become more clueless, or both.

Consider the percentage of recently-reporting companies that beat Wall Street’s expectations. Among the firms in the S&P 500 SPX, -0.23%   that have reported this earnings season, for example, 76.1% beat the analyst consensus and just 16.8% missed.

Nor are these recent results a fluke. Over the last 16 quarters (or four years), according to Standard & Poor’s data, more than two-thirds of all S&P 500 companies’ earnings beat expectations. In no individual quarter was the share beating less than 63%.

Beating expectations has now become expected, in other words.

In contrast to the largely clueless analysts, however, investors appear to be seeing through the expectations game. They have stopped getting particularly excited by beating expectations, for example. At the same time, they severely punish companies that fail to clear the artificially low hurdle that their expectations game has created.

This asymmetry is evident in the performance of a company’s stock immediately after reporting its earnings. During the current earnings season, the stocks of companies’ missing expectations fell 2.3% following their earnings reports, versus just a 0.6% average gain among companies that beat. (Data is from J. P. Morgan Markets.)

Furthermore, as you can see from the accompanying chart, this penalty for missing the analyst consensus has been steadily growing this year.

In investing, giving in to your emotions can cut your return by about 1.56 percentage points a year. Should you leave the job to an emotionless robo adviser instead?

These developments have implications not just for investors who focus on earnings surprises and earnings revisions. All of us need to cultivate a healthy dose of cynicism about analysts’ earnings estimates.

Perhaps the best way to immunize yourself from the expectations game is to focus on long-term growth rather than quarter-to-quarter results. That’s because the longer-term trends can’t be manipulated in the way in which quarterly results can.

Another reason to focus on long-term growth is that companies that expend enormous amounts of energy on manipulating short-term results may very well be sacrificing their long-term growth in the process.

Courtesy of marketwatch.com