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[hedgehawk]

I got this from Briefing . com. If you have not seen this it is worth the 5 min read.


http://www.briefing....40TheBigPicture



Earnings Reality Check
Last Update: 30-Apr-07 08:29 ET

The stock market has rallied strongly the past few weeks on the basis of "better than expected" earnings. In fact, first quarter earnings reports have been only modestly bullish. The market gains have outpaced the fundamentals.

The Earnings Game

To fully understand how earnings compare to expectations it is important to understand how the earnings game works.

Ahead of every quarter, Wall Street analysts have optimistic forecasts for company earnings. Then, as the quarter progresses and the earnings reports approach, estimates drop quickly (and sometimes sharply).

This conservative approach lowers the bar of expectations. As a result, every quarter without fail, about two-thirds of companies beat the average Wall Street earnings estimate. Furthermore, the aggregate percentage gain in the S&P 500 companies' earnings typically exceeds Wall Street estimates by 2% to 3%. This is such a highly predictable result that it becomes expected.

When a company reports earnings, it is often said that "earnings beat expectations" or something similar. In fact, what has really happened is that earnings have been compared to the recently-lowered average analyst estimates, not true market expectations.

First Quarter Example

The first quarter earnings reports fit this pattern.

On January 1, the average forecast for the S&P 500 in aggregate was for 8% earnings growth. The S&P 500 was at 1418.

Over the next few months, earnings estimates came down steadily. This was in part due to the concerns about the economic outlook. It was even more so due to the typical earnings game patterns. By the end of the first quarter, the average forecast for S&P 500 aggregate earnings had dropped to 3.5% to 4%.

As the earnings reports have been coming out, it has been common for analysts and journalists to say that concerns had set in about earnings during this period. Yet, it is impossible to find that in the charts.

The S&P 500 index on April 1 was 1420, almost exactly where it was at the start of the year. The market was recovering well from the Shanghai-induced February 27 plunge. There is no evidence that lowered expectations for earnings had actually been priced into the market despite lowered analyst forecasts.

Then, as the reports started coming out, they started beating analyst forecasts (expectations?) by a bit more than the typical amount that occurs in most quarters. This was naturally hailed as "better than expected."

Now it appears that first quarter earnings for the S&P 500 in aggregate are on track for about 8% earnings growth. Earnings growth will be almost exactly in line with forecasts as of the start of the quarter.

Over this period since the start of the year, the S&P is up 5.3%. That is about a 15% annual rate of growth, well ahead of the 8% earnings growth. All this because earnings are being described as "well ahead of expectations" even though earnings are in line with forecasts as of the same time frame.

The Earnings Outlook

The outlook for second and third quarter earnings has not improved with the first quarter results.

Forecasts have stayed near 5% for the second quarter and have actually dropped to near 2% for the third quarter. The earnings deceleration is expected to continue.

Of course, the earnings game rules suggest that second quarter forecasts will soon start dropping. The bar needs to be lowered further. By the time earnings reports start coming out in early July, forecasts for the second quarter could be down to 2%. If the economic outlook remains murky, third quarter numbers could drop to near zero by the end of the summer.

First quarter earnings may have beaten lowered "expectations," but the overall earnings outlook has not improved. The market rally can not be ascribed to improved expectations for the immediate quarters ahead.

The Other Key Fundamental

Stock prices are ultimately a function of earnings growth expectations and interest rates. All other factors are simply influences on these two key fundamentals.

There is no reason for the stock market to have rallied so strongly since the beginning of the year based on these fundamentals.

As noted above, first quarter earnings are actually headed close to forecasts as of the start of the year. They are in line with expectations.

The interest rate outlook, meanwhile, has deteriorated.

At the beginning of this year, expectations were that the Fed would cut interest rates this summer and again in the fall. Now, expectations are that the Fed will probably hold interest rates steady through the summer, with about a 50-50 chance of a rate cut by the end of the year.

Interest rate expectations have become less bullish and provide no rationale for the stock market gains since the start of this year.

What it All Means

First quarter earnings are nowhere near as good as the hype they have produced.

A broader perspective than simply comparing earnings to recently lowered estimates makes this clear.

First, earnings are not any better than was expected at the start of the quarter. Second, an 8% gain over the first quarter of 2006 would represent a deceleration from the double-digit gains of recent quarters. Third, the deceleration is highly likely to continue in the second and third quarters. There is even a risk that third quarter earnings go negative if economic trends do not pick up. None of this is strongly bullish.

The fact that earnings are ahead of recently-lowered Wall Street estimates is standard operating procedure. There is no evidence to support the contention that there were greater fears of poor earnings this quarter given the stock market rally since the beginning of the year. It is simply not true that the lowered analysts forecasts represented lower expectations priced in to stocks.

The first quarter earnings reports are not bearish. They are simply not nearly as bullish as widely presented. The fundamentals of stable interest rates and modestly rising earnings provide a long-term modestly bullish outlook.

The problem is that the 21% surge in the S&P 500 index over the past ten months has outpaced earnings gains and has produced a rising price/earnings multiple that is not justified based on the stable interest rate outlook and decelerating earnings growth.

The enthusiasm about the earnings reports is fueled by the continued stock market momentum more so than a sound analysis of the actual earnings trends. Don't buy into all the hype.

- - Dick Green, Briefing.com