The Independent Market Observer

What to Watch for This Earnings Season

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Apr 13, 2018 3:23:12 PM

and tagged Commentary

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earnings seasonEarnings season is here again, and expectations are high. In fact, expected growth is at the highest level since 2011, with growth expected to continue through 2019. You would anticipate markets to respond positively. So, the fact that the stock market has instead just been bouncing around is a bit concerning. What is going on—and what does it mean for the future?

High expectations

At the first level, the fact of very high expectations means the chance of disappointment is much higher. Most companies do their best to dial down analyst expectations, to make them easier to beat. With the general levels of optimism this quarter—deserved optimism, but still optimism—that has been tougher to do. Companies are therefore going to have a harder time beating expectations. As such, the percentage of beats is likely to drop, which could weigh on sentiment.

Second, even if companies do meet and beat the high expectations, how will the market react to such beats? Normally, when a company beats, the stock responds by rising, as investors cheer the unexpected gains. Beats on earnings are, in fact, a proven indicator of a stock likely to outperform in the future. That bump depends, however, on the company and stock being priced at a level that allows for such a gain. If investors expect something even better, a beat that isn’t big enough can actually lead to the stock going down. This often suggests that markets are fully priced and that investors’ expectations are starting to outrun reality.

From excitement to ho hum?

And that is what we are seeing now. In the past quarter, there has been a shift in how the market responds to beats: from excitement to ho hum. Signs are that will also be the case this quarter, notably with J.P. Morgan’s earnings beat this morning. According to Zack’s Investment Research, analysts expected quarterly earnings to increase from $1.65 a year ago to $2.28, but instead earnings came in at $2.37 per share. Historically, that would have pushed the stock price higher. While the stock price did go up in early trading, it is now down. You certainly can’t use one stock as a definitive guide, but this is a very large company that is widely followed and traded. So, as an indicator, it is useful. Investors may have expectations that are simply impossible to meet. If this kind of reaction is common this earnings season, that could weigh on the market.

The tariff impact

The other thing to watch for this quarter is what companies have to say about the tariffs. There won’t be any immediate impact, of course. But with the prospect of policy action, companies are likely to start weighing in on what tariffs might mean. Thus far, there has been minimal actual impact. It is pretty much all theater—and the markets have, after pulling back briefly, largely ignored the issues. The very real concern here is that as companies start responding to the risks, and as they get incorporated into earnings estimates, the tariff impact comes back in a more permanent way.

Expectations versus reality

The main thing here is the gap between expectations and reality. Normally, that gap closes up as reality beats expectations. But there are signs that is starting to reverse. For the tariffs, the gap is also between expectations, which are that the risk will blow over and what might be the emerging reality. That is the story arc this season.

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