Many top U.S. companies have been cutting forecasts for their earnings at a rapid pace in recent weeks, but an analysis of historical data shows that rather than being a cause of despair it may be a reason for investor optimism.
Big companies are almost always conservative, regardless of whether business is humming along or not, but by one measurement, the first quarter has been the ugliest for corporate outlooks since 2001. Among S&P 500 companies making forecasts, 4.5 have come in below Wall Street estimates for every one above them, according to Thomson Reuters data.
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Downbeat outlook announcements from companies, though, have a way of creating the conditions for big gains.
First, the share prices of the companies tend to decline. Then, Wall Street analysts often lower their own estimates in line with the corporate outlooks. Finally, having created an environment of lower expectations, many companies manage to beat the forecasts (their own and the analysts) after all when the results are announced.
"The companies are doing a very good job of guiding the analysts lower to pave the way for what I call 'manufactured earnings surprises,'" said Nick Raich, chief executive of The Earnings Scout, an independent research firm specializing in earnings trends, in Cleveland, Ohio. "That's the way the earnings game is played."
S&P 500 earnings were expected to increase just 1.5 percent for the first quarter when earnings season began and the latest estimate stands at 1.1 percent. But investors and strategists say that earnings will more than likely look substantially better when the season comes to a close.
So far there have been 108 warnings for first-quarter results. The 4.5-to-1 negative-to-positive ratio is the seventh worst for any quarter since 1996. Yet four of the previous six of those dire warnings periods have been followed by quarterly gains in the S&P 500; the average gain for those four with gains is 6.68 percent while the average gain for all six periods is a much lower 0.6 percent.
A 6.68 percent gain this quarter would take the S&P 500 to 1,674 by the end of June, extending a rally that has already taken it to record highs.
A look at a greater sample shows the persistence of this pattern. Of the 20 quarters with the most negative ratios since 1996, the average gain in the S&P 500 in the following quarter was 2.3 percent. By comparison, the average move for all of the past 68 quarters dating back to 1996 is 1.7 percent.
It is in the best interest of companies to avoid disappointments. Warnings have outnumbered positive pre-announcements in all but five of those 68 quarters, and yet companies almost always report results above analysts' expectations.
The last time earnings have fallen short of analysts' forecast was the fourth quarter of 2008 was when the impact of the financial crisis was so sudden and severe that it took time for everyone to assess its depth.
In the last 16 quarters, in all but one, the analysts' expectations at the beginning of earnings season have been exceeded by anywhere from one to 22 percentage points, with an average difference of 6.4 points.
On average, 63 percent of companies beat earnings estimates, according to Reuters data going back to 1994. Investors have come to anticipate this, and recent gains may be in part due to the belief that earnings, once again, will not be as dire as forecast.
"The buy-side takes sell-side analysts with more than a grain of salt," said John Manley, chief equity strategist for Wells Fargo Advantage Funds in New York. "I don't think anybody's being fooled who doesn't want to be fooled."
This time, Wall Street analysts may be cottoning on to the usual move by companies to lower earnings expectations. Analysts have not been reducing forecasts at the same pace as the companies themselves.
"There's been a kind of a decoupling," said Dan Suzuki, U.S. equity strategist at Bank of America-Merrill Lynch in New York. However, Suzuki wrote in a note last week that changes in management forecasts tend to precede analyst revisions, so the outlook could theoretically worsen.
Full-year S&P 500 earnings are expected to hit a 2013 record of $111.62, based on an aggregate measurement of analysts' forecasts of earnings per share for the companies in the index, surpassing last year's record of $103.80, according to Thomson Reuters data.
CONSUMER COMPANIES SUFFER
This time around, consumer companies sound among the most depressed, blaming increased U.S. tax rates and ongoing weakness in Europe for lowered forecasts.
Consumer discretionary stocks currently have a negative-to-positive pre-announcement ratio of 6.5 to 1, Thomson Reuters data shows.
More than half of the roughly 30 corporate outlooks in the consumer discretionary sector are warnings from retailers, which analysts said could be the result of the higher U.S. payroll tax, a delay in income tax refunds and other recent U.S. fiscal policy changes, such as automatic spending cuts known as sequestration.
"In essence, we've had a tightening of fiscal policy which includes the sequester but also includes tax rate increases," said Bucky Hellwig, senior vice president at BB&T Wealth Management in Birmingham, Alabama.
Target , for example, offered a cautious outlook and reported a lower-than-expected profit in late February, followed by Nordstrom , with a disappointing profit forecast in the same month.
A number of companies, including some airlines and other travel-related businesses, have said they have been hit by the U.S. government spending cuts. Delta Airlines recently cut its first-quarter revenue forecast, saying federal budget cuts hurt demand for travel by government staff.
(Reporting by Rodrigo Campos and Caroline Valetkevitch, editing by David Gaffen and Martin Howell and Theodore d'Afflisio)