Bespoke Investment Group

Estimate Revisions and "The Earnings Season Racket"

Doug Kass penned a column for TheStreet.com on Wednesday titled "The Earnings Season Racket."  Kass argues that the earnings "beat" rate is so high this quarter because of lowered estimates, and that "companies almost always beat earnings forecasts even during rough economic periods."  Below is a portion of his column:

While it has been widely advertised by chest-thumping bulls in the media that at least two-thirds of the companies that have reported third-quarter earnings have beaten forecasts, there was less than meets the eye to third-quarter profits as in many cases the "beats" were on lowered estimates.

What is often being ignored is how orchestrated earnings season has become, not only that the beats are from lowered and depressed guidance but that, in many cases, there have been high-profile forward-quarter guide downs.

The reality is that companies almost always beat consensus earnings forecasts, even during rough economic periods. Investor relations departments and Wall Street analysts are very good at getting numbers down to the right level before reports are released. As a result, the actual results vis-a-vis expectations or consensus do not vary materially from historical experiences, in good times and even in bad times.

The argument that earnings are beating estimates simply because estimates had gotten so low has been one that bears have been using this entire bull market.  In reality, however, estimates have increased significantly in recent months.  Back in October 2008, net earnings revisions (% of increases to decreases in revisions) had tanked to multi-year lows.  But it also bottomed that month and then traded sideways until February 2009.  Just prior to the market lows in March, however, the net earnings revisions ratio began to tick higher.  Earlier this summer, the earnings revisions ratio actually moved into positive territory, which meant anaysts were raising estimates for companies more than they were lowering them.  Leading up to this earnings season, the percentage of companies raising estimates hit a two-year high.  Upside estimates have been outpacing downside estimates for a few months now, and companies have still been able to beat estimates at a high rate, which we believe is a major reason for the rise in the overall market.

Kass' argument that companies almost always beat consensus forecasts even during tough times also needs some explaining.  Over the last decade, 62% of the tens of thousands of earnings releases were better than analyst expectations.  But the beat rate has had pretty big swings from a quarter to quarter basis that has ranged from 50% to nearly 75%.  While the majority of stocks are going to beat in any given quarter, some quarters are significantly better than others. 

Below is a chart showing the quarterly earnings "beat" rate going back to 1998.  As shown, the beat rate was strong during the last couple quarters of 1999, and it peaked in Q1 2000 just as the market peaked.  From that point until Q3 '01, the "beat" rate remained below 60% and trended lower.  From Q4 '01 (which would have been the numbers released in January/February 2002) to Q1 '04, the beat rate progressively increased each quarter. This coincided with a big increase in the stock market as well.  The last peak that we saw in the quarterly "beat" rate came in Q3 '06 when 73% of companies beat estimates.  The number remained above 60% through Q3 '07, but it had started its drift lower.  This downtrend continued all the way until Q4 '08 (numbers released in January/February '09) when the "beat" rate hit a low of 55%. 

The earnings season in April and May of this year was the first increase in "beat" rates since Q1 '07.  In that earnings season, the "beat" rate came in at 62%, which was surprisingly positive at the time, and one reason why the market did very well during over the spring and summer.  The "beat" rate got even better last earnings season (68%), and we're on pace to have the best "beat" rate since at least '98 this quarter.

To brush off the earnings "beat" rate because earnings "almost always beat estimates" is not a good idea.  We believe it's important to follow the trend in quarterly "beat" rates, as a trend higher is indicative of a strong market, while a trend lower is a negative sign.  Surprisingly better than expected earnings reports have been a big part of the current bull market. 

If Kass wants a bearish argument, he could actually make the case that the high "beat" rate this quarter will most likely be the peak in the cycle since it is so high.  It's going to be tough for the next earnings season to have a stronger "beat" rate than this quarter, which could mean the start of a downtrend.  But nowhere in Kass' column does he mention this.

In conclusion, the data shows that companies have been beating raised estimates and not lowered ones during this bull market, and the direction of quarterly "beat" rates is a trend that investors should definitely follow.

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Key Earnings Reports Next Week

More companies are set to report earnings next week than this week, but the big names have already come and gone.  There are a lot of second-tier reports to focus on next week, however, and below we provide a list of the names that investors will be following most.  As shown, Corning (GLW) and Verizon (VZ) kick off the week with reports on Monday morning, while BIDU will surely be active after the close.  JCI, UA, VLO, and X report Tuesday morning, and Visa (V) will give us some important data on consumer spending on Tuesday afternoon.  GD, IP, WLP report Wednesday morning, while there aren't any big hitters reporting Wednesday after the close.  On Thursday, we get reports from CME, EK, MOT, NEM, ODP, PG, S, and XOM, which will be the biggest day of the week for earnings.  Finally, Chevron (CVX) finishes off the week with earnings on Friday before the open. 

Below we provide a list of all of the key companies listed above.  For each stock, we also highlight their earnings and revenue beat rates, how often they have raised guidance, and their average one-day change on the first trading day following their reports going back to 2001.

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Amazon Hits All-Time High

Amazon.com is currently trading up $20 to $114.35 after reporting strong earnings numbers after the close yesterday.  As shown in the chart below, this is a new all-time high for AMZN, which made its prior high as a high-flying internet stock during the dot com days.  During the crash of the early 2000s, AMZN got all the way down to $5.97.  What a comeback!

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Dollar and Stocks Still Moving in Opposite Directions

The red line in the chart below is not an inverse of the S&P 500.  It's actually an intraday chart of the dollar.  No sooner than one goes up, the other goes down.

  

Largest S&P 500 Companies

Given that Technology has the largest weighting in the S&P 500, it comes as little surprise that four of the ten largest companies in the index are from that sector.  While most would expect to see MSFT near the top of the list, AAPL is currently the fourth largest company in the S&P.  The stock that was left for dead a little more than ten years ago now has a larger market cap than JPM, PG, JNJ, GE, and IBM.  A couple more good days and Apple will also be bigger than Wal-Mart!  GOOG is another name in the top ten that wasn't even in existence ten years ago. 

The list of largest companies also illustrates the top heaviness of the index.  With a total market cap of $1.98 trillion, the ten largest names represent just under 20% of the total market capitalization of the index.  Their market cap is equal to the combined market cap of the smallest 321 companies in the index!

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Sector Weightings; Financials Move From 6th to 2nd

The weighting of the Financial sector in the S&P 500 has made a huge move since the March lows.  After being the biggest sector of the market for six years in a row, the weight of the Financials dropped all the way down to 8.9% (6th place) on March 9th, 2009.  After the recent rally we've had, the Finanial sector has nearly doubled its weight to 15%, and it now ranks 2nd behind the Technology sector (18.8%).  Technology, Financials, Industrials, Consumer Discretionary, and Materials are sectors that have gained market share during the bull market, while the other five sectors have lost share.  The Financial sector has gained the most, while Health Care has lost the most (16.1% to 12.5%).

The charts below highlight historical S&P 500 weightings for each sector going back to 1990.  The red lines in the charts represent the historical average for each sector.  As shown, the Financial sector dropped well below its average during the collapse, but it has moved all the way back up to its average in just 7 months.  Technology remains above its average and has been trending upward, while Energy, Consumer Staples, and Health Care are above their averages but trending downward.  Industrials, Consumer Discretionary, and Materials are below their historical averages but trending upward, while Utilities and Telecom are below their averages and trending downward.

 

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Groundhog Day: September vs October

Sometimes we feel like Bill Murray's character in the movie Groundhog Day, where he relives the same day over and over again.  If you have been watching the market recently and also keep finding yourself getting a feeling of Deja Vu, you're not alone.  The S&P 500's performance in October has nearly been an exact replica of most of September.  The chart below highlights the intraday trading of the S&P 500 from September 2nd to September 30th (left axis), and compares it to the intraday trading from October 2nd through the 21st (right axis).  Although it began from a higher price, the S&P 500 has followed the September blueprint nearly tick for tick!

From the low of the month, both rallies lasted thirteen trading days.  In September, the S&P 500 rallied by 8.8%, and in October the rally was 7.9%.  Then both rallies ended on the 14th day of the advance, when the S&P 500 hit a new high for the year only to sell off and close at its lows for the day.  If (big if) October continues to follow the September script, this implies that equities would continue to trade sideways to lower for the rest of the month.

 

 

Stocks Reacting Negatively to Earnings

While 75% of companies have beaten earnings estimates this reporting period, their share prices have not done very well at all.  Below we highlight the average change on the first trading day following earnings reports for all companies that have released numbers this quarter.  For companies that report after the close, we look at its next day change.  For companies that report before the open, we use that day's change.

As shown below, the average one-day change for all companies reporting earnings has been -0.95%.  Companies have been averaging a gap down of 0.64%, and another decline of 0.30% from the open to the close.  Companies that have beaten estimates have averaged a gap up of 0.63% at the open and a decline of 0.39% from the open to the close.  This amounts to a measly 0.25% full day gain for companies beating estimates.  Companies that have missed estimates are getting killed this earnings season, which isn't surprising given the extremely high earnings beat rate.  As shown, companies missing estimates have averaged a gap down of 5.6% at the open and a slight gain of 0.13% from the open to the close for a full day change of -5.58%.

First Impressions Don't Mean Much to Dick Bove

They say first impressions mean a lot, but apparently not to Rochdale analyst Dick Bove.  This morning following WFC's earnings release, the analyst was positive on the stock and said it was a good report.  Now, later in the day he is reportedly advising clients to sell the stock.  Below we highlight the headlines courtesy of Briefing.com.

08:07

WFC Wells Fargo: Rochdale analyst Dick Bove, on CNBC, says he assumes that Wells Fargo, US Bancorp, and Morgan Stanley should perform well in the market today and help lift financials (30.46 )

15:29	WFC Wells Fargo follow up (29.66 -0.80) -Update-
	Bloomberg reports that Rochdale's Bove cuts WFC to Sell from Neutral... See 15:20 comment.

Now some will argue that Bove's initial opinion was based on incomplete information since he didn't have time to go over the report.  While that may be the case, is it responsible for analysts to come on TV and give their opinion on a stock without looking over a just released earnings report?

Also, Bove still has a buy or neutral rating on every other financial stock he covers, so should we really interpret his downgrade of one company as a negative for the entire market?  The fact that traders decided to sell everything based on this event shows that many out there are probably just looking for an excuse to sell.

  

ABC Consumer Comfort Index Still Near Lows of the Cycle

There's been a decent amount of commentary today regarding last night's release of the not so widely followed ABC Weekly Consumer Comfort Index.  At a level of -50, the index remains deeply depressed, and it is one of the only measures of confidence that has yet to show any meaningful rebound.  The double dippers out there would have you believe that this is the canary in the coal mine, and a sign of things to come. 

A look at the historical record of this index, however, shows that its reliability is weak at best.  In the two prior recessions during which this index has been in existence, the indicator kept declining when the recession was well in the rear-view mirror.  Following the 1990 recession, the index didn't show a meaningful uptick until late 1993, and it didn't turn positive until February 1997.  In the 2001 downturn, it wasn't until early 2003 that the indicator began to turn higher, and it never turned positive until November 2006.  After looking at this indicator's prior record, one quickly realizes why this is one confidence indicator that most people have never heard of.

Sector Beat Rates This Earnings Season

Through yesterday, 157 US companies had reported earnings, and 77.1% of them had beaten EPS estimates.  This "beat" rate is very strong from a historical perspective, but remember that there are still quite a few reports left this season.  Below we break down the EPS "beat" rate by sector.  As shown, nearly every stock in the Technology and Health Care sectors have beaten estimates.  In the Technology sector, 27 out of 29 stocks have beaten their bottom line estimates, while 12 of 13 Health Care stocks have beaten.  Industrials and Materials are the other two sectors doing better than the market as a whole.  On the opposite side of the spectrum, only 60% of Energy stocks have beaten earnings estimates.  Financials and Consumer Discretionary have "beat" rates of less than 70%, while Consumer Staples is at 75%.

Become a Premium Plus member to track this and many other earnings season datapoints on a daily basis in our Morning Earnings Report.

Best and Worst Performing Stocks This Earnings Season

While 77% of US companies have beaten earnings per share estimates so far this earnings season, the average stock that has reported has actually declined 0.72% on its report day.  (For stocks that report after the close, we use its next-day change, and for stocks that report before the open, we use that day's change.)  Heading into earnings season, the market was at extreme overbought levels, and companies are finding it difficult to see an increase in share prices even when their earnings reports blow away the numbers.

Some companies have managed to do well, however.  In the first table below, we highlight all of the US companies that have gone up more than 5% on their earnings report days (S&P 500 companies are outlined in black).  As shown, Lexmark (LXK) has seen the biggest gain at 15.91%, followed by Renaissance Learning (15.67%), Helen of Troy (12.5%), Werner Enterprises (12.38%), and Lufkin Industries (LUFK).  Other notables on the list of big winners include Gannett (GCI), Tempur-Pedic (TPX), CSX, Bank of New York (BK), and Harley-Davidson (HDI).

More companies have gone down more than 5% on their report days than have gone up more than 5%.  Volterra Semi (VLTR) has had the worst reaction to its earnings report with a one-day decline of 18.42%.  Boston Scientific (BSX), Great A&P Tea (GAP), McClatchy (MNI), MGIC (MTG), Brinker (EAT), Nokia (NOK), and Domino's Pizza (DPZ) have all gone down more than 10% on their report days this earnings season.

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Chinese ADRs Outperforming Stocks in China

In a late July report to Bespoke Premium clients, we noted that even though the sizzling stock market in China was generally closed to outside investors, US investors still had plenty of (and in some cases superior) options to invest in Chinese stocks through the vast number of Chinese ADRs trading on US exchanges.  There are currently over 125 Chinese ADRs that trade on US exchanges, and of those, 58 have market caps of more than $300 million. 

Now that the Chinese equity market has stabilized and is back on the upswing, we updated our chart comparing the performance of the Chinese stocks listed locally in China and their US listed peers (ADRs).  While locally listed Chinese stocks are still well below their peaks from August, our basket of US listed ADRs remains in a well-defined uptrend and has broken out to new highs for the year.

 
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Sector Relative Strength

The charts below show the relative strength of the ten S&P 500 sectors versus the overall index.  Given the interest in the Transports by Dow theorists, we have also included the relative strength of that group.  In each chart, a rising line indicates that the sector is outperforming the S&P 500 while a declining line indicates underperformance.  We have also included dots showing each time the Fed has recently cut rates (red) or left rates unchanged (black dots).

• As shown in the charts below, only four (Consumer Discretionary, Energy, Materials, and Technology) of the eleven sectors shown have outperformed the S&P 500 over the last year. 
• While Financials have been one of the leading sectors off the March lows, they are still underperforming the S&P 500 by a wide margin since 10/08. 
• Not surprisingly, given all the debate in Washington over Health Care, that sector is near its lowest levels in the last year in terms of relative performance.
• Finally, with the consumer supposedly tapped out, it's ironic that the Consumer Discretionary sector is near its best levels of the last year.

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S&P 500 Testing Earnings Season Trendline

With the equity market's negative reaction to positive earnings reports overnight and this morning, the S&P 500 is currently testing the uptrend that it has been in since the beginning of earnings season when Alcoa (AA) reported.  Currently, the uptrend stands at 1,090, so as the index drifts down near that level, traders can expect at least an attempt to bounce at support.

The real star of earnings overnight was Apple Computer (AAPL), which reported much stronger than expected numbers.  While the stock traded at new all-time highs in after-hours trading ($204.85), it has had trouble holding $200 ever since the opening bell.

Apple Trading Sharply Higher on Earnings

We've been posting on the race to $200 between Goldman Sachs and Apple for a couple of months now.  Based on after-hours trading, it looks like Apple will make a nice run for the finish line tomorrow.  After blowing away third quarter estimates, Apple is trading up about $13 to $203 as of 5 PM ET.  If the gains hold, Apple will not only beat Goldman to $200/share, but it will also mark a new all-time high for the stock.

For those interested, over at Bespoke Premium we'll be analyzing how Apple usually trades the following day after trading up so much in after-hours trading.  Apple has been a big winner for us here at Bespoke.  We added the stock to our Bespoke Premium Model Portfolio on October 8th, 2008 at a price of $86.91.  At $203/share, our gain in the stock currently stands at 133%.  While we aren't eager to hit the sell button, we have been upping our stop price on the trade as the stock has moved higher to ensure that we are able to lock in the significant gains we've gotten.  For those interested in viewing all of the stocks in our Model Portfolio, please subscribe to Bespoke Premium today.

  

Will The Vix Crack 20 Soon?

The VIX volatility index slipped below 21 earlier today and currently stands at 21.15.  This is the closest the VIX has gotten to 20 throughout the entire bull market, and marks a 75% decline from the closing high of 80.86 seen during the financial crisis.

The VIX has now been above 20 for 287 consecutive trading days, which is the longest streak since 1990 when our daily VIX data begins.  In the bottom chart, we provide a historical look at the VIX along with all of its streaks of daily closings above 20.  We've only seen two other periods where the VIX was above 20 for 200 straight trading days or more, and those ended at 239 days in June 1999, and 236 days in May 2003.  In terms of market performance following these long periods of high volatility, the S&P 500 was on the verge of making a mutli-year peak when the VIX broke below 20 in 1999, but it did very well in the months and years following the drop below 20 in May 2003.

How Traders Spent Their Weekend

Judging by the performance of Motorola (MOT) today, it appears that a lot of traders were watching sports this weekend.  Throughout the weekend, broadcasts of the MLB baseball playoffs and the NFL were peppered with ads for a cell phone that mocked many of the features not available with the iPhone.  The commercials begin with a series of "iDon't..." phrases flashed across the screen.  Examples included, "iDon't have a real keyboard.", "iDon't have interchangeable batteries.", "iDon't run simultaneous apps.", 
 etc.  Then the screen turns dark, and a somewhat hard to read "droiddoes" flashes across the screen.

While no specific company was mentioned, the web-page shown in the ad (www.droiddoes.com) takes you to a Verizon Wireless website advertising an upcoming Google Android powered phone from Verizon called DROID.  The phone is being produced my Motorola, and was jointly produced with Google and Verizon.  While the phone isn't out yet, the initial buzz on it has been extremely positive.  According to an article on TechCrunch, the Droid poses "a significant challenge to the iPhone more than any other phone to date. The Palm Pre could have been that challenger, but it lacked the Verizon network, and users were unimpressed with the hardware.  According to people who have handled the device, the Droid is the most sophisticated mobile device to hit the market to date from a hardware standpoint.  When you combine that with the Verizon network, you’ve got something that is most definitely a challenger to the Jesus phone." 

Given that Motorola has been reeling in recent years due to its failure to put out a popular handset since the Razr in 2004, the prospect of a new hit in the smart-phone sector has investors excited.  As shown below, the stock is up nearly 8% today on no other news.  The experience of the Razr also underscores the rapid nature of innovation in the cell phone industry, and how today's hot item can quickly become tomorrow's has-been.  At its height, the Razr was nearly just as popular as the iPhone is today.  Now you wouldn't even know where to buy one.

  

 

Country Default Risk

Below is a table highlighting current credit default swap (CDS) prices for the sovereign debt of 38 countries.  The CDS prices represent the cost per year to insure $10,000 of debt for 5 years.  The US CDS price is quoted in Euros.  The list is sorted by year-to-date change, and as shown, default risk in Russia and Australia is down the most in 2009 at -77%.  US default risk is down 68.1%, which is the most of any G-7 country.  Japan is the only country that has seen default risk actually rise in 2009, but it also had the lowest CDS price of any country at the start of the year.  Overall, while CDS prices are down sharply in 2009, they remain well above where they were at the start of 2008, so there's still plenty of recovery work to do. 

 

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Stay On Top of Earnings Season With Bespoke

Last week we introduced our new Morning Earnings Report over at Bespoke Premium.  Along with a summary of key statistics throughout earnings season, each morning the report will provide all of the US earnings reports that were released after the prior trading day's close and so far that morning.  For each company, we provide both actual and estimated EPS and revenue numbers, any guidance that was issued, and the price reaction to the report in pre-market trading.  Using our Interactive Earnings Report Database, we also include each stock's average open to close performance on report days based on whether it gaps up or down at the open.  The stocks are broken into two categories depending on whether they are trading higher or lower in the pre-market.  The key number to look at for those looking to make trades is the historical average open to close change for each stock.  Companies that have reported a triple play (beat EPS and revenue estimates and guided higher) are shaded in light green.

Please click the thumbnail below to view an example of our Morning Earnings Report from Friday.  For investors looking to keep track of each day's earnings reports and find possible trades, there simply isn't a better report out there.  Subscribe to Premium Plus to receive our Morning Earnings Report on a daily basis.