Earnings season, or the art of managing expectations

The sad truth is that earnings forecasts have much more to do with managing expectations, and hence fatten the bonuses of the companies’ executives and the stock market’s brokers than with providing the investors with an accurate picture of what is going to happen in the future.

Companies and analysts lower the bar, so then they can claim that they exceeded the expectations.

According to Greg Harrison, from Thomson Reuters, in the long run (one year ahead) stock brokers and financial advisors are at the most optimistic point when divining the companies’ future. Then, they start to lower their estimates. This is often accompanied with further cuts announced, under the euphemism of ‘guidance’, by the very same executives of the public companies. The result is a downward spiral in the profits’ forecasts.

Harrison has titled his analysis Estimates too high, low? Check the calendar.

There is another trend—companies are becoming more and more profitable. According to Harrison, “net income growth for the S&P 500 is 3.5 percent, more than two percentage points below the EPS [Earnings Per Share, Wall Street’s favorite metric for earnings] growth rate of 5.7 percent, meaning that declining share counts have boosted earnings growth.” Are public companies becoming more productive while the rest of the economy isn’t?

Not really. What companies are doing is buying back shares, mainly because they have so much money that they do not know what to do with it, and also because the lower the number of shares, the higher the price, and, again, the bigger the executives’ compensation. As Harrison explains, “lower share counts have boosted earnings per share growth in the index as a whole, and in each sector except for utilities”.

So, earnings season is, to some extent, a charade. As Kopin Tan has explained in Barron’s, already 19 percent of Standard and Poor’s 500 companies “have told investors to brace for worse results” in 2014, in spite that the US is going to have strong growth, Europe is leaving its recession behind, Japan is also expanding and even the emerging markets do not seem poised for a big slowdown.

The percentage of companies who think that 2014 will be better than 2013? 2.6 percent.