Earnings Reports Coming – What Does Less Trimming Mean to Investors?

Wednesday, March 31, 2010

The Wall Street Journal, in “Strong Earnings Season Appears Baked In” (Ahead of the Tape, by Kelly Evans, March 30, page C-1), describes an unusual pattern leading up to this quarter’s earnings reports: Both analysts and corporations are trimming expectations less than usual. (Each group typically trims its forecasts near quarter end to avoid disappointment when earnings are announced. Positive surprises are desirable; negative are not.)

The article says less trimming could mean we will see fewer positive surprises and, therefore, less stock market gain. But there is another possible explanation…

First, April is important because first quarter earnings reports start off the new year. These earnings serve as a foundation for analysts’ full-year expectations. For reference, here is how the stock market responded to the April earnings reports during the 2000’s:

April’s earnings reports for 2010 are expected to show large growth compared to 2009. But the stock market has already “baked in” much of that improvement. That’s why it is up so much from last year.

The question the reporter poses is whether the smaller amount of pre-report trimming means that corporations and analysts have changed their tunes. Are they now more optimistic and certain? If “yes,” that would imply fewer positive surprises and, therefore, less stock market bounce.

But, let’s say both groups still view earnings forecasts to be uncertain, and they remain wary of negative surprises. Then, what would their lack of trimming mean? Answer: They now see earnings looking even better than their already good forecasts. If so, they have no need to change their announced expectations to produce a good dose of positive surprise. And that would be just the thing to spur a stock market rise.

One important side note: Stock market valuations do not look overly high. In fact, they appear attractive. Here is the Dow Jones Industrial Average table from yesterday’s write-up:

The key measure is the 11.9 forward P/E ratio (equivalent to the 8.4% earnings yield). It is based on the next twelve months’ earnings, so, as first quarter earnings reports are released, any surprises will show up here.

So… The lack of trimming could mean first quarter earnings reports come in more-or-less in line with current expectations. Or they could once again come in with positive surprises, meaning the results would be even better than the already good forecasts.

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Note: The possibility that positive earnings surprises could exceed expectations, thereby driving the stock market higher, is an example of the  “upside risk” from an underweight position in US stocks. (See “Long Ignored, ‘Upside Risk’ Returns – Is ’Buyers’ Panic’ Next?”)

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