The Coming Earnings Collapse, Value Traps, and the Road to Recession

Of all the inane reasons to be bullish about equities, "beat the Street" hype is near the top of the list. The fact is, in aggregate, ever since Regulation-FD (Regulation Full Disclosure), companies always beat the street.

In Surprising Optimism in Face of Weekly Global Equity Carnage, I noted nearly every quarter, even in 2008 and 2009, the majority of firms beat estimates. Here is the way the process works:

• Corporations give analysts "tips" regarding profit expectations.
• Those profit expectations are purposely low.
• Wall Street analysts lower estimates, if necessary, as the quarter progresses such that corporations can "beat the Street."
• If corporations are going to miss and need an extra penny, they change tax assumption or make other "one time" adjustments as necessary.
• Corporations beat the Street by a penny with "pro-forma" (after adjustment) reporting.

Understandings Earnings Estimates

A couple of readers asked for a historic chart of "beat the Street" metrics

I just happen to have one, with thanks to Understandings Earnings Estimates by James Bianco on the Big Picture Blog:

Aggregate S&P 500 earnings have beaten expectations for 50 straight quarters, including the current quarter. As we explained last July:

The chart below highlights the inception of SEC regulation “FD” (aka, Fair Disclosure). Before FD roughly 50% of companies beat expectations, as would be the case if analysts were trying to get it right. Now that companies have to disclose to all at the same time, we believe their investor relations departments are masters at “guiding” analysts just below actual earnings.

This way the companies “beat” expectations and get the positive press and accolades that come with it. Further, it seems that everyone is happy with this apparent gaming of the system. This is why we believe the percentage of companies that beat expectations is a meaningless statistic. The game is designed for this to happen, even when earnings are collapsing (during 2008′s epic collapse in earnings more than 50% of companies still beat expectations).

Percentage of Companies that "Beat the Street"


Click to enlarge

The last time companies failed to "beat the Street" was third quarter of 1998. At the earnings trough in third quarter of 2008, 58% of companies in the S&P 500 still managed to "beat the Street."

Sentiment, Not Earnings, Key to Returns

If this "beat the Street" talk was not pathetic enough in and of itself, the fact remains that sentiment, not earnings, is the key to stock market performance.

I discussed this concept at length in a pair of posts earlier this year. Please read the following if you have not yet had a chance to do so:

• Negative Annualized Stock Market Returns for the Next 10 Years or Longer? It's Far More Likely Than You Think
• Anatomy of Bubbles

Value Traps

On June 20, in Value Traps Galore, I noted Berkshire (BRK-A), Citigroup (C), and Bank of America (BAC) were "value traps".

At that time Citigroup had a price-to-book valuation of .64, and Bank of America a price-to-book valuation of .50.

Citigroup price-to-book valuation is now .52 and Bank of America price-to-book valuation has fallen to .38.

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