• April 19, 2024

Earnings Season Preview: Watch for Guidance, Not Results

N.Earning season, the quarterly onslaught of financial reports from public corporations, begins last week. As we get closer, I’ll make a prediction: I expect the majority of the S&P 500 companies that report to beat analysts’ estimates for earnings per share (EPS). If you’re unfamiliar with how earnings work, this may sound like a bold prediction with bullish ramifications. However, if you are more familiar with the markets, you will know that my forecast actually means very little.

Last quarter, 79% of the S&P 500 companies exceeded these estimates. That was above average, but not nearly as much as you might think. The multi-year average for beats is around 70%. So when I predict that more than half will beat the consensus-based EPS forecast for the first quarter of 2021, I do so with some confidence. In fact, there is a chance that more than three quarters of companies will report a positive “surprise” this quarter as well.

Look at the circumstances. The estimates for each quarter are generally based on a few factors: the results for the same quarter last year and management’s guidance for the quarter just ended. This quarter covers last year’s results, which covered the start of the pandemic, and is extremely difficult to interpret. Many CEOs used Covid as an excuse not to issue guidelines in the past year. Analysts go into it in the dark and given their tendency to underestimate even when they have information and data, estimates tend to be conservative even after a series of upward revisions.

Because of these circumstances, neither the year-over-year earnings growth nor the percentage of Beats in this earnings season will mean much or nothing. What should investors look out for?

First is the forward guidance when it returns. There is a growing mindset among CEOs that it is ridiculous to evaluate the performance of a company, and therefore its CEO, based on its ability to meet quarterly goals. You are encouraged to underestimate at all times, hence the large number of beats, which means that the guide must be taken with a pinch of salt and adapted to reality. However, this also means that the lack of the estimates derived from this false guide will be severely punished. I mean, if 70% of companies beat and you know the guidelines have been conservative, failure must be terrible, right?

Not necessarily. It could be the product of some short-term issues that do not affect the company’s prospects, or it could be the result of larger investments or R&D than originally planned, which is likely to improve prospects. The problem is that errors in the consensus estimate are usually penalized for pretty much whatever the reason. So, if you’re a CEO blamed for the stock price, why bother guessing and, more worryingly, why bother investing?

Still, some brave souls might try to use the Covid-related suspension of leadership as an excuse to stop trying to predict the future and I wish them the best of luck. Most will likely give in to the pressure and continue the guessing game. Analysts and institutional investors need to have a basis for their estimates that will also blame someone if their projections are wrong. Hence, they are likely to punish anyone who refuses to provide a forecast for the future.

Even if we know the guidance will be skewed, it will matter to some extent. The reaction of the market depends on the prevailing sentiment. If the upward move continues, a low lead is understandably prudent and discounted, while a good lead is seen as evidence that everything is rosy in the garden. On the other hand, if fears of inflation, or a surge in weekly unemployment rates, or a careless statement by a Fed executive or anything else is upsetting sentiment, the opposite is true.

Earning season is usually a crucial time for investors, not just in terms of individual stocks but also in terms of general market direction. However, this quarter is different. There has not been a pandemic of this magnitude since 1918, so no one knows what to expect at this point in recovery. Nor do they know what last year’s numbers meant and how circumstances will affect CEOs’ estimates for the year ahead.

The most likely outcome, therefore, is that the general reaction to wins this season is subdued, but slightly bullish with an above average number of wins. Hitting record highs on major indices isn’t a bad thing at all, but I’ll be looking for something else. If there is a tangible departure from CEOs’ short-term guidelines, while the market will punish those who do so in the short term, it will prepare us for more stability and more profit in the future.

The views and opinions expressed are those of the author and do not necessarily reflect those of Nasdaq, Inc.

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Jack

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