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Friday, July 28, 2006

1. Earnings 2. Reaction 3. Guidance

Barry Ritholtz wrote a very interesting and timely article on earnings season and how the market reacts to such news. With the market seeming to halt despite all the positive earnings, it makes one think as to whether the good news has already been factored in. If so, then could the flipside be true? That bad earnings have not yet been discounted and that lowered guidance will pose as a surprise? Mr. Ritholtz has gathered data supporting this in the article below. Enjoy the read but don't forget to pack your parachute....


We are about halfway through earnings season, and it looks like another quarter of double digit year-over-year earnings growth. This now makes something like 14Qs in a row. That's the good news.
To a large degree the market has already priced in these double digit year-over-year earnings gains. We see that in several data points which we discuss below.

I look for divergences, things that are different from last quarter. And on that score, there are several issues worth exploring, as they portend that something is changing in both the markets and the broader economy.

Our first chart "comes to us from Birinyi Associates Chart of the Day, and looks at the S&P500 misses versus beats on earnings: So far, we are seeing 72% of companies actually beating consensus. That ties for the best in 4 years. Misses are a mere 10% -- also the best in 4 years.

S&P500 Earnings Beats vs Misses

Courtesy of Birinyi Associates

This clearly shows the quarterly numbers are coming in better than expected.

Now is where things get interesting. Merely knowing earnings are doing well is insufficient information for investors. The key question is, how much of the good earnings are built in? How are stocks reacting after the good reports?

The chart below shows exactly that. Here are the following day returns after both upside and downside surprises:

Courtesy of Birinyi Associates

Look at the left chart in green -- that is EPS Beats. The reaction to good news is the smallest its been since 2002 (see the blue bar at bottom left), and way below the recent average if 1.2%.

That implies that most of the good news is already built into stock prices.

On the right in red, we see the EPS Misses. The next day reaction is the most severe we have seen in four years. Stocks that miss get brutally punished, and are beaten up way more than the prior four year average of 2.37% the following day.

This implies that the bad news is not yet factored in.

Finally, lets look at the last of the earnings call elements: Guidance. According to Ashwani Kaul, Reuters Fundamental Market Analyst, guidance has dramatically diverged from the past few quarters, shifting to a negative 2 to 1. Particularly warning of weaker earnings and/or revenues has been the Tech sector, and Consumer Cyclicals.

To some degree, this may be reflected in the price already. The Nasdaq has gotten slammed, and it may simply be a matter of the market anticipating a slowing (Tech is far more cyclical than most people realize).

This may also explain why the misses are getting beaten up -- the combination of a miss and guiding lower could what is the divergence from prior quarters.


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