Why this Earnings Season Could Be a Game Changer

Earnings season always adds an extra dose of volatility to the markets. But as third-quarter profit reports begin coming in fast and furious this week there is a lot more riding on results than usual.

The degree to which companies exceed … or fall short of expectations can make all the difference for the market’s direction.

Several high profile companies including Coca Cola, Citigroup, and IBM already reported their most recent financial results this week. Investors are bracing for many more in the days and weeks ahead. Over 200 public companies will report this week, and nearly 700 more profit reports follow next week, according to data from Bespoke Investment Group.

First the good news: As you can see in the chart below, the bar has been set pretty low for third-quarter results as U.S. economic growth clearly slowed during the third quarter. Analysts are forecasting a decline of 2.6 percent in overall S&P 500 profits for the three months ended September.

Click the chart for a larger view.

This would be the first decline in S&P 500 profits after eleven straight quarters of positive growth!

And as always, expectations for the future could either be a blessing or a curse for the stock market as I’ll explain.

Blessing in Disguise …

The way the money game is played on Wall Street includes this rule: Public companies are supposed to under-promise and over-deliver on sales and earnings.

Analysts set their estimates for all 500 S&P stocks, typically based on low-ball guidance from the companies themselves. This process establishes a hurdle rate for companies to beat each quarter.

With not-so-great expectations coming into third-quarter reporting season, the stock market has a very low hurdle to clear this time around.

That’s a plus. Because if most companies in the S&P 500 are able to beat estimates by just a few percent, which is typically what happens, the market could easily have a sizeable year-end relief rally driven by positive earnings surprises that beat expectations.

Curse Those Expectations …

Every game has scorekeepers, and the Wall Street money game is no exception.

In this case, the scorekeepers are Bloomberg, Fact Set, Zacks, and other third-party firms that collect and track all the earnings estimates from each Wall Street analyst who has an opinion on every one of the 500 S&P stocks.

It’s a mind-numbing task. But someone’s got to keep score so investors can judge actual results against estimates to see which companies are beating or falling short of expectations.

The trend in earnings estimates — whether they are rising or falling — comes mainly from public comments that companies make about their business prospects.

This is called “guidance.” And since most Wall Street analysts can’t tell the difference between preferred-stock and livestock, they rely heavily on this “guidance” to adjust their earnings estimates.

Why Earnings Season
Could Be a Game Changer

Guidance is an important part of the game, perhaps the most important, because guidance has a great influence on expectations about future sales and profit growth, not to mention current stock prices.

Now the bad news: One reason to be cautious this earnings season, regardless of actual third-quarter results is the curse of great expectations for fourth-quarter profits, combined with the curse of negative guidance.

As of the end of last week, the vast majority of forward looking guidance has been negative in recent weeks. In fact, more than three-out-of-four companies projected earnings that fell short of estimates. That’s not a good trend.

Moreover, it’s the highest percentage of negative earnings guidance ever recorded by FactSet since they began keeping score in 2006!

That’s bad enough. But adding to current earnings season anxiety is the fact that expectations for fourth quarter profit growth remain at a very lofty level.

Again according to FactSet, the S&P 500 is expected to post 9.7 percent profit growth in the three months ending December. That’s a pretty high hurdle rate for the stock market to clear, considering the slowdown in global growth AND the record amount of negative earnings guidance from public companies at present.

That’s why the stakes are high as third-quarter earnings season begins in earnest this week and next. The clock is quickly running out on the Wall Street money game, 2012 edition; just one-quarter left for companies to come from behind and score 9.7 percent profit growth.

Watch for one of these two scenarios to play out …

The Fourth-Quarter Fumble Scenario …

If companies expect to fall short of the goal line for 2012 sales and profits, we’ll find out soon enough, because they will say so during third-quarter conference calls; guiding earnings estimates lower for the remainder of this year.

So if you notice a blitz of negative sales and profit news in the weeks ahead, it could be game-over for the stock market.

The Fourth-Quarter Touchdown Scenario …

However, if most companies beat earnings estimates and issue upbeat guidance about fourth-quarter prospects, it could be time to go-long for a game-winning fourth quarter rally that would make Eli Manning proud.

Needless to say, I’ll be watching the early returns very closely this earnings season for clues about which scenario is playing out, and so should you. The outcome will determine the likely direction stocks take through year end.

Let the games begin … and may the odds be ever in your favor!

Good investing,

Mike Burnick

Mike Burnick, with 30 years of professional investment experience, is the Executive Director for The Edelson Institute, where he is the editor of Real Wealth Report, Gold Mining Millionaire, and E-Wave Trader. Mike has been a Registered Investment Adviser and portfolio manager responsible for the day-to-day operations of a mutual fund. He also served as Director of Research for Weiss Capital Management, where he assisted with trading and asset-allocation responsibilities for a $5 million ETF portfolio.