TToday is the last day of trading in July and we are roughly in the middle of the Q2 earnings season. Let’s step back a little and take stock of what we’ve learned from the earnings announcements so far. It seems like two things are clear. First, analysts continue to underestimate the American economy and the companies that drive it, and second, the market reflects their pessimism.
The underestimation of income is nothing new. On average, over two-thirds of companies have exceeded Wall Street’s consensus forecast for quarterly earnings per share (EPS) for the past decade. This begs the question, why do we even bother paying attention to these estimates? I mean, if you’re wrong about your job 70% of the time, you will likely get fired. Even known inaccurate weather forecasts have a better hit rate these days!
Still, the fact remains that analysts’ estimates are influential, so it’s important to understand why they keep falling short on the low side. The answer to this seems, at least in part, to be that the starting point for their calculations is usually the companies’ own profit forecasts. Obviously, when you’re a CEO forecasting performance, it makes sense to under-promise and exceed, rather than the other way around. Therefore, the guidelines, the starting point for estimates, are generally conservative.
And yet, if a company makes lower than expected forecasts, its stock will be hit. I know this seems reasonable on the surface, but knowing that they tend to underestimate, most of these sell-offs are buying opportunities.
A good example of this was yesterday when First Solar (FSLR) have published their results. They exceeded expectations for earnings per share, but lowered the forecast for the next quarter. This caused their stock to fall nearly 5%. They also lowered the forecast in their Q1 report three months ago, which is why the estimates for earnings per share for the second quarter were just $ 0.60 versus the $ 0.77 it hit. FSLR recovered strongly afterwards, why should it be any different this time? (I should say at this point that I put my money where my mouth is and have been on FSLR for a long time at the moment).
This scenario also plays out in a macroeconomic sense. The market as a whole has basically stalled, despite the fact that companies are reporting high profits.
On average, the S&P 500’s earnings are up 86%. Obviously, that result is compared to an exceptional quarter last year, but the average over-expectation this quarter is 18% compared to about 5% in the past, and profits are now well above pre-pandemic levels. However, if we look at the graph above for S&P 500 futures, which dates back to the first real winning day of this season on July 13th, you can see that that day they opened at 4,377 and traded at 4,378.5, like me write this morning. A profit jump of 86%, which exceeded expectations by 18%, meant that the index futures were able to gain 1.5 points.
If that doesn’t make sense to you, join the club. I understand traders and investors are concerned about the slowdown in growth, the Delta and the Fed, but the same worries were about three months ago. Nonetheless, we are breaking records in earnings growth here with a gain of around 10%. Ultimately, it depends on whom you trust more: your previously unfounded fears or the cold, hard facts of massive and increasing profits.
I stick with the latter. So if a company that has historically exceeded its own forecasts is hit because that forecast is lower than expected this time around, I will continue to see this as an opportunity to buy a good stock at a discount.
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