Weighing the Week Ahead: Will Q3 Earnings Disappoint?

Earnings season follows a familiar, four-step pattern.

  1. Preliminary — Analyst estimates are too optimistic, perhaps because they "go native."
  2. Confession –  Adjustment and warnings as companies "pre-announce," usually when the report will be a disappointment.
  3. Announcement — Actual results with explanations and outlook for the future.  There is an initial market reaction to the news.
  4. Interpretation and Spin — The company does a conference call where analysts either congratulate management or ask probing questions.  The stock usually keeps trading during the conference call, and often provides a real-time interpretation of the management discussion.

It is often not easy to interpret.  The conventional wisdom is that analysts are too bullish  on earnings estimates and also set the bar too low for the actual report.  Most seem not to notice that these are contradictory positions.

Rather than starting from scratch on this subject, I recommend that readers take another look at something I wrote more than two years ago.  I explained one of our regular themes at "A Dash."  Most of the punditry uses words rather than data.   The key point is that the earnings story is complicated, which provides many opportunities for spinning. 

"Instead, there is a long laundry list of tests:

  • Earnings — comps from last year.
  • Earnings — meeting expectations.
  • Earnings — meeting the "whisper number."
  • Revenues — should meet all of the above.  The market is very
    skeptical of earnings from cost-cutting, even though that shows smart
    management and can easily be reversed.  It is a clear-cut bias.
  • Gross margins falling — another thing that can be wrong.  Even
    though it might be correct to compete by cutting margins, the pundits
    will pounce.
  • Gross margins rising –  evidence of unsustainable earnings on a long-term basis.
  • Foreign sales — another no-win area for management.  If you
    suggest that sales were lower, then pundits will infer Europe weakness. 
    If you try to cite currency changes, you get the opposite spin.
  • Ignore current earnings.  Look backward.
  • Ignore forward earnings.  Look backward.
  • Ignore strong earnings.  Look at multiple year growth estimates.
  • Ignore long-term growth estimates.  Those are too bullish.

The added complexity of the earnings story is not helpful to the
investor.  For consideration by investors who want to look more deeply
into this process, I now posit "The Miller Rule."

The more variables, the more spin potential."

Even those who are accurate in forecasting actual earnings may be losers in the short run based upon this list.  I'll offer my own take in the conclusion, but first let us do our regular review of last week's news.

Background on "Weighing the Week Ahead"

There
are many good lists of upcoming events.  One source I
especially like is the weekly post from the WSJ's Market Beat blog.  There is a nice combination of data, speeches, and earnings reports.

In
contrast, I highlight a smaller group of events.  My theme is an
expert guess about what we will be watching on TV and reading in
the mainstream media.  It is a focus on what I think is important
for my trading and client portfolios.

This is unlike my
other articles at "A Dash" where I develop a focused, logical
argument with supporting data on a single theme. Here I am simply
sharing my conclusions. Sometimes these are topics that I have
already written about, and others are on my agenda. I am putting
the news in context.

Readers often disagree with my
conclusions. Do not be bashful. Join in and comment about what we
should expect in the days ahead. This weekly piece emphasizes my
opinions about what is really important and how to put the news in
context. I have had great success with my approach, but feel free
to disagree. That is what makes a market!

Last Week's Data

Each week I break down events into good and bad. Often there is
"ugly" and on rare occasion something really good.
My working definition of "good" has two
components:

  1. The news is market-friendly. Our personal policy preferences are not relevant for this test. And especially — no politics.
  2. It is better than expectations.

The Good

The news last week was mostly positive, including these highlights.

  • The dollar death cross has triggered!  For more than a year the dollar has been inversely correlated with stock prices, so this technical indicator is bearish for the dollar and bullish for stocks.  See Min Zing in the WSJ for a full account.
  • Romney pulls even among likely voters according to the Pew Research Center, among others.  (Please note the above definition of good=market-friendly.  We are not cheering for either candidate.  We are analyzing the implications for investments.  Right or wrong, the market likes Romney).  The effect did not last for even a day, however, perhaps because of some tortured logic about Romney firing Bernanke, whose term ends in January, 2014.  Sites analyzing the Electoral College result still show Obama in the lead.

10-8-12-1

  • Initial jobless claims dropped dramatically.  This sparked more silliness about manipulation of the data.  The seasonal adjustments can be tricky at this time of year, which is why we emphasize the four-week moving average.  Hats off to Invictus and Barry Ritholtz (see here as well) for helping everyone keep focus on this issue.  Here is a helpful chart from Calculated Risk:

WeeklyClaimsLongOct112012

  • Michigan consumer sentiment spiked almost to pre-recession levels.  This report deserves more respect.  It is an excellent concurrent indicator, but reflecting several factors.  In the last year or so the spike in gas prices and the political shenanigans have polluted the results.  Normally this is a good indication of employment and consumption.  For it to increase at a time when gas prices are elevated and the political silly season is in full swing is very positive for employment.  Here is Doug Short's excellent chart, my favorite for this series:

Michigan-consumer-sentiment-index

We are almost back to normal levels.

 

The Bad

The actual data last week was pretty good, but the stock result was bad.  This happens, and it can be meaningful.  Let us take a closer look.

  • The world economy is weakening with the threat of a double-dip recession according to new reports from the IMF and Brookings.  (via the FT). 
  • Insider selling  sends a warning (via Mark Hulbert).  I am a big fan of Mark Hulbert, but I am a little uncomfortable with this article.   There are always reasons for insiders to sell, since the stock and options are part of a compensation package.  (I am the chair of the comp committee for a small public company).  It is also natural that selling is higher when the stock price is higher.  Insider buying is a much better indicator than selling.   But we should watch all indicators, so I advance this for discussion.
  • The Fed Beige Book suggests only modest growthSteven Hansen at GEI reports.  His research provides an interesting compendium of Fed comments before the last two recessions, which have an eerily similar quality.
  • Gasoline prices  threaten the consumer.
    The Bonddad Blog tracks this and many other high-frequency indicators (some of which are positive).  You really need to follow the complete weekly article — just as I do:)
  • The early reaction to earnings.  We will know a lot more about this next week, but the early indication is intense skepticism.  There seems to be a negative tone.
  • Small business reactions and forecasts remain negative, especially from the highly partisan National Federation of Independent Businesses (NFIB).  Here is a nice account from GEI, and a chart from Doug Short:

NFIB-optimism-index

 

The Silver Bullet

I occasionally give the Silver Bullet award to someone who takes up
an unpopular or thankless cause, doing the real work to demonstrate
the facts.  Think of The Lone Ranger.

This week's award goes to Cardiff Garcia at FTAlphaville for his thoughtful and reasonable analysis of the housing turnaround.  It started with Roger Altman's op-ed piece in the FT has a nice explanation of why A housing boom will lift the US economy.

This is an unpopular viewpoint, so the mocking tweets started.  Garcia waded into the fray with a well-timed and data-filled rebuttal.  Rather than attempting a summary which could not do justice to the original post, I urge you to read it.  This topic is absolutely crucial to understanding economic prospects.

The Indicator Snapshot

  It is important to keep the current news in perspective. My weekly snapshot includes the most important summary indicators:

The SLFSI reports with a one-week lag. This means that the
reported values do not include
last week's market action. The SLFSI
has moved a lot lower, and is now out of the
trigger range of my pre-determined
risk alarm. This is an excellent tool for
managing risk objectively, and it has
suggested the need for more caution. Before
implementing this indicator our team did
extensive research, discovering a "warning
range" that deserves respect. We identified a reading of 1.1 or higher as a place to consider reducing positions.

The SLFSI is not a market-timing tool,
since it does not attempt to predict how people will interpret
events.  It uses data, mostly from credit markets, to reach an
objective risk assessment.  The biggest profits come from
going all-in when risk is high on this indicator, but so do
the biggest losses.

The C-Score is a weekly interpretation of the best recession indicator I found, Bob Dieli's "aggregate spread."

Bob and I recently did some videos explaining the recession
history.  I am working on a post that will show how to use this method. 
As I have written for many months, there is no imminent recession
concern.  I recently showed the significance of by explaining the relationship to the business cycle.

The ECRI recession call is now over a year old.  Many have forgotten
that at the time of the original prediction, the ECRI claimed that the
recession was already underway by September of 2011.  See New Deal Democrat's carefully documented discussion, including the original video, at the Bonddad Blog.

The ECRI keeps moving the goal posts on this prediction, suggesting
that we will only know about a recession after many months because the
data will be revised lower.  For the few die-hards who are still taking
this seriously, you should read the careful, thoughtful, and data-driven work
from Dwaine Van Vuuren.  He is taking up the key elements in
determining recessions and looking at whether revisions affected the
timing of past recessions.  He does this by comparing the difference
between the original observations and the final revised version.

Please note that Dwaine has actually done this research, while the ECRI has not supported its claims.

Here is a key chart on employment:

PAYEMSREV

Dwaine's observations:

"The first is that the real-time data results in several false
positives (false alarms) as indicated by the “1″ markings. The second
observation is that for the most part, the signalling of the start of
recessions is near-identical between the real-time and revised versions
of the growth rate. The only exceptions are 2008 (tagged “2″), 1957 and
1959 where the revised data signalled recession earlier (meaning the
real-time observer would have been late in his/her assessment that a
recession was indeed underway) and point “3″ where the real-time data
was actually earlier in signalling recession.

On the whole, the revised data provided earlier signalling 2 more
times than the real-time data, giving it a slight edge. Whilst revised
data results in a 3-month smoothed growth rate that can differ to that
of the real-time growth rate, that difference seems to be isolated to
the expansions and contractions, but not so much around the turning
points themselves."

 

Dwaine's RecessionAlert service offers a free sample report.  Anyone following them over the last year would have had useful and profitable guidance on the economy.

Doug Short's most recent update asks, ECRI Weekly Leading Indicators: Time to Recant the Recession Call?  Doug has been an open-minded monitor of the various arguments, so his analysis deserves respect.  I do question his premise this week, however.  Rather than recanting the recession call, I think that the ECRI should predict the end of the recession.  After all, the ECRI said that we were in a new economic era of slow growth and more frequent recessions.  Their WLI has turned higher, which everyone following their data sees as good news.  Maybe it is time for them to "predict" that the recession will end within the next few months!

Readers might also want to review my new Recession Resource Page, which explains many of the concepts people get wrong.

Indicator snapshot 101212

Our "Felix" model is the basis for our "official" vote in the weekly Ticker Sense Blogger Sentiment Poll.
We have a long public record for these
positions.  This week we continued our neutral forecast.
These are one-month forecasts for the poll,
but Felix has a
three-week horizon.  Felix's ratings have continued to drift lower. 
The penalty box percentage measures our confidence in the forecast.  That indicator is moving higher, indicating less confidence in the neutral rating.  It has been a close call over
the last few weeks, as the ratings moved out of bullish territory.

[For more on the penalty box see this article.
For more on the system
ratings, you can write to etf at newarc
dot com for our free report package or to
be added to the (free) weekly ETF
email list.  You can also write
personally to me with questions or
comments, and I'll do my best to answer.]

The Week Ahead

This week brings plenty of economic data, and much, much more.

The "A List" includes the following:

  • The next Presidential debate (T).  Playing to undecided voters in swing states.
  • Initial jobless claims (Th).  Extra interest after last week's "mystery" decline.
  • Building permits (W).  The best leading indicator for housing.
  • Chinese GDP (W).

The "B" List" includes these entries:

  • Retail sales (M).  Confirmation of solid consumer confidence?
  • Industrial production (T).  Important component of economic growth.
  • Housing starts (W).  Widely followed, but volatile.
  • Leading indicators (Th).  A favorite recession indicator for some.
  • Existing home sales (F).  Will the bottoming in housing continue?

The other news includes regional Fed surveys from NY and Philly.  I put little stock in these, but a big surprise moves the market.  We also have European leaders meeting at the end of the week. and some Fed speeches.

The most important news will be earnings!

Trading Time Frame

Felix has continued the neutral posture of the last few weeks. It has been a close call between neutral and bullish for several weeks.  Felix has done very well this year, becoming
more aggressive in a timely fashion, near the start of the
summer rally.  Since we only require three buyable sectors, the
trading accounts look for the "bull market somewhere" even when the
overall picture is neutral.  The ratings have moved lower again this week, and
we are now down to one trading position, as I predicted last week.  We might be completely in cash by the end of this week.

Investor Time Frame

Each week I think about the market from the perspective of different
participants.  The right move often depends upon your time frame and
risk tolerance.  Individual investors too frequently try to imitate traders, guessing whether to be "all in" or "all out."

Many have been out of the market and worry that they have missed the
rally.  A few months ago there were too many worries for them to
invest.  Now there is a fresh supply.

The traders (including Felix) are getting more cautious for a variety
of reasons.  Some are trying to lock in profits to earn their bonuses. 
Investors face a completely different problem.

Take what the market is giving you!

If you have been following our regular advice, you have done the following, in a proportion appropriate for your individual circumstances:

  1. Replaced your bond mutual funds with individual bonds (bond funds are very risky!)
  2. Sold some calls against your modest dividend stocks to enhance yield to the 10% range.
  3. Added some octane with a reasonable allocation of good stocks.

These opportunities are still available, but it might be a limited time offer.  We have collected some of our recent recommendations in a new investor resource page
— a starting point for the long-term investor.  (Comments and
suggestions welcome.  I am trying to be helpful and I love feedback.  We have a good discussion going on bonds versus funds, and I plan a separate article that will provide a further forum.)

Final Thoughts on Earnings Season

Last week I noted that we were entering the season of fear.  There was definitely a change in tone last week, with little response to good news.  Stocks had the worst week in months while the data were actually somewhat positive.

Thousands of companies will report earnings in the next few weeks.  When the overall earnings story is mixed, we can expect many to present a downbeat outlook.  There is little reason to make bold predictions.  Executives can be cautious, citing problems in Europe, China, and Washington.

The actual earnings "beat rate" will probably be close to historical norms, but the short-term outlook depends on psychology and trader sentiment.  Just as it did last week, this can change swiftly.

This is why agile traders can afford to be cautious, while investors should be seizing opportunities.

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6 comments

  • RB October 14, 2012  

    Jeff,
    With regards to housing, given that we are scheduled to be closing escrow in a week (and hopefully that will be a smooth process), I’m not exactly a doomsdayer on housing. For me, the reasoning was simply that in 2012, buying became cheaper than renting (20% lower in our neighborhood in Orange County, CA). I suspect that there are many with my viewpoint, for whom price trend is less important than monthly payment especially after having waited for many years (i.e., pent-up demand). This sort of attitude could help in stabilizing house prices in desirable neighborhoods.
    Having said that I’d be curious on your take on this analysis by Steve Keen (hat tip @dafowc), particularly Figures 4 and 5 correlating mortgage acceleration with house price changes. The shadow inventory, re-defaults from HAMP loan mods, sluggish growth per blue chip forecasts and demographic shift (baby boomers selling rather than buying) could perhaps keep a lid on price appreciation for a few years at least.

  • Proteus October 14, 2012  

    Jeff, I’m a bit surprised about your comment on the market liking Romney. Several other blogs have posited Wall St secretly favors Obama, since he would likely support Bernanke, and Romney probably wouldn’t. Any thoughts on this?

  • RB October 15, 2012  

    Altman and Garcia seem to argue that household formation will drive a housing recovery which will lift the economy. As outlined here however, the echo boomers have been hit hard by the economy. What seems to be clear from demographic trends is (a) baby boomers will be net sellers (b) rental demand is likely to be strong over the coming decade. What is not clear is when echo boomers are likely to be in a position for home-ownership. It seems like a chicken-and-egg situation – which goes first, home-ownership by echo boomers driving an economic recovery or the other way around?

  • RB October 15, 2012  

    As described here , one of the biggest hindrances to home-ownership by echo boomers is student loan debt and the inability to meet down payment requirements despite renting being more expensive than monthly cost of ownership. I guess there could be a tie-up with Steve Keen’s debt deflation theory here.

  • oldprof October 15, 2012  

    Proteus — Bernanke’s term is up in January, 2014. So what is likely to change from the election?
    For the moment, let’s stick with the Romney victory side.
    My expectation is that a President Romney would behave differently from a Candidate Romney. This should not surprise anyone who has followed Presidential politics for more than a few years.
    My working forecast has three parts:
    1) Romney cannot change the voting membership of the Fed in the short term.
    2) New Fed Chairs, from either party, tend to see the organization as activist. People forget that Bernanke was a Republican appointee.
    3) Sitting presidents do not advocate tight money. I invite an examination of history. A President Romney might well replace Bernanke, but the new candidate would not reject the current Fed policy.
    This obviously deserves an actual post, but this is my best effort in the comments. See here for a balanced analysis: http://thehill.com/blogs/on-the-money/economy/261823-romneys-plan-to-dump-bernanke-sparks-anxiety-on-wall-street
    Good question, and thanks!
    Jeff

  • oldprof October 15, 2012  

    RB — As usual, you raise a number of interesting questions. I’ll try to delve deeper but tonight (Mrs. OldProf’s birthday) is not a good time.
    Let’s just say that I personally know many young people from the echo generation who have recently bought.
    Let’s not look at this as a light switch, but something where some will qualify, and others will not.
    And some people are able to buy on 5% down with mortgage insurance, the same way I did in my first home….
    Jeff