Albert Edwards On Why "The Farce That Is US Reporting Season" May Be Different This Time
As everyone who follows earnings seasons knows all too well, one of the traditional games companies play with sellside research analysts is to push earnings estimates lower just ahead of earnings announcement only to beat by the thinnest of margins, setting off a buying rally in the stock that more than offsets the gradual decline it may have experienced in the preceding run down. This observation is one half of Albert Edwards' note to client from this morning. He says: "It’s that surreal time of the quarter, just ahead of the reporting season, when US companies cajole compliant analysts into reducing their profit forecasts so that on the day the company can record a positive earnings surprise. Companies place so much store on beating analysts’ estimates that they play this ridiculous game of guiding down analysts numbers in the weeks or even days ahead of the announcement, only to beat depressed forecasts by a penny on the day (see chart below). The angle in the press and in analysts’ reports is then that this constitutes ‘good news’ despite, more often than not the outturn undershooting the market estimates of only a few weeks previous. Nuts!" The other half focuses on how this particular earnings season may be different, and why unlike previously, earnings downgrades may be for real this time: "We show that in contrast to expectations of a second half recovery, economic leading indicators are actually signalling the reverse, as is our favoured measure of analyst optimism. Hence the recent spate of profit warnings – which have resulted in a deeper than normal round of downgrades – may be the beginning of something far more undermining to equity prices over the next six months." So is this time, especially in the absence of the artificial boost to everything that is QE, any different? With earning season imminent, we will finally find out just how well the corporate sector (not having represented the actual economy for a long time) can stand on its own in the absence of monetary fiscal and stimulus for the first time in years.
Edwards' graphic presentation of the "reporting season farce":
In early May, prior to the renewed jitters about US economic slowdown, we pointed out that analyst optimism seemed to be turning down (albeit from a very high level), and that this was probably a prelude to worse than expected economic data. We have updated that chart and it shows optimism has deteriorated further and that the change in optimism has fallen deep into negative territory (see left-hand chart below). For a more timely reading of the profits situation, my Quant colleagues aggregate the data from the company level on a weekly basis (see righthand chart below). Both at the US and global level this shows analyst optimism falling away more sharply than it did prior to the previous report around three months ago).
In his latest Global Earnings Estimate Analysis, Andrew notes that a new trend towards EPS disappointment may be emerging. And although he does not believe that analysts’ optimism has any particular lead qualities, especially relative to stock market prices (see right-hand chart below), what is clear is that the change in analyst optimism has a tendency to lead the official economic leading indicators (see left-hand chart below), thus suggesting there is more bad news to be reported in coming months.
And in this environment, it will prove difficult for the equity market to de-couple from this weak fundamental trend. For as we know from Japan, in the Ice Age, the equity market will dance to a cyclical tune.
As to what Edwards' indicators that the current decline in the economy is more than just a soft spot, he reverts to two things we points out last week: declining consumer confidence and the near record spread between the ISM new orders and inventories data.
Regular readers will know that we watch the leading indicators closely. Studying Japan a decade ago we came to the conclusion that in a post-bubble, Ice Age world, the equity cycle and economic cycle become unusually synchronous. Prior to that bubble bursting, the equity market enjoyed a closer positive correlation to bond prices than the profits cycle and the secular trend was PE expansion driven by lower bond yields. In the Ice Age, the secular trend sees equity PEs contract, despite lower bond yields. The secular trend of PE contraction intensifies ferociously during economic contractions.
So we note that once again leading indicators in the US and indeed around the world have turned downwards. To be sure, at this stage they are not signalling anything particularly catastrophic, but the trend undoubtedly calls for decelerating activity in the months ahead (see left-hand chart below).
Always the gentleman, Edwards does admit a dose of mea culpa here:
Now you might reasonably point out that we said exactly the same thing in the middle of last year and we were wrong! But I believe that the unravelling economy last year was saved from slipping into recession by Ben Bernanke quickly reaching for the printing press in the form of QE2. Now, with many Fed governors now openly hostile to QE3, it will probably take far more in the way of bad news compared to last year to prompt the Fed to take out its increasingly discredited monetary wand.
As noted previously, the most notable thing about the upcoing earnings season is that it will finally take place without the artificial props of either monetary or fiscal policy and as such it will provide the clearest indication of how to look at corporates on a standalone basis (granted with ZIRP, interest rates are at record lows: that particular benefit to the bottom line will take a while to be factored in, especially once rates finally commence their gradual, or very sharp, move higher.
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