Why the Coming Earnings Reports Are So Important

Wednesday, September 22, 2010

Yesterday I wrote about the US stock market’s third hurdle approaching: The next quarterly earnings reports. (See “US Stocks’ Third Hurdle Just Around the Corner.“) What might we expect, and why do they matter?

First, expect small, positive “surprises”

As always, many eyes will be on the quarterly earnings and whether they exceed current estimates – and by how much. Companies and analysts know that investors prefer positive “surprise,” so they try to keep expectations slightly below actual forecasts. (For more about this, see “Earnings Reports Coming – What Does Less Trimming Mean to Investors?” – March 31.)

The real surprise, then, is earnings being significantly above or any amount below expectations.

Second, the real message will appear in the annual forecasts

Investing is the ultimate “What have you done for me lately?” business. No sooner have earnings been reported then investors look ahead to the next earnings report, particularly the annual forecasts. The reason? If analysts and investors like what they just saw, those earnings projections should remain steady or, even better, be raised.

Here is the 2010-2011 earnings forecast picture for the Dow Jones Industrial Average (DJIA). Note the increases in the 2010 estimates as earnings were reported over the past year. Thus far, 2011 estimates have held steady.

Third, 2010 “estimated” earnings are 50% real, soon to be 75%

As each 2010 quarter is reported, one-quarter of the annual earnings become actual. Once the next set of reports are in, there will only be one quarter to be added, so we shouldn’t expect significant changes in the 2010 forecasts.

Note: The earnings shown in the graphs are for the four quarters making up most or all of the calendar year, even if the company has a fiscal year that is different.

However, the 2011 earnings remain 100% estimated, so the next reports can influence them, particularly since we are that much closer to the new year.

Fourth, what investors pay for the estimates indicates confidence vs. uncertainty

As 2011 approaches, that year’s projected earnings become more important. As investors gain confidence in the forecasts, stocks’ valuations (think price/earnings ratios) tend to rise.

Here is the picture of the past fourteen months.

Last, an underlying trend unrelated to earnings adds a potential valuation change

Investors appear to be regaining interest in US stocks. If this continues, we could see continued stock price rises beyond the earnings growth rate.

So… We are at an interesting point. Following its April-June drop, the stock market appears to have built a base. Investors’ seem to be shifting from big picture fears (that haven’t materialized) to company growth prospects (that are evident). IF the next quarter’s earnings continue the trend, “base-building” could become “bull market.”

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