The Downside Of Optimism On Earnings

By E.S. BROWNING
Hopes are running high for this quarter's earnings season. Given Wall Street's sometimes upside-down logic, that could pose a problem for stocks.

The floodgates for first-quarter-profit reports open in earnest Monday, when Alcoa Inc. releases its results, the first member of the Dow Jones Industrial Average to do so.

The worry is that, with the Dow already up 9% in the past two months amid hopes of an economic recovery and strong corporate profits, stocks could do the same thing they did last earnings season: sell off when the good news actually arrives.

Stocks typically trade on expectations, ahead of actual news. They rise when investors think future earnings reports will be strong. One of Wall Street's oldest sayings is investors buy on rumors and then sell on news, taking profits just as the rest of the world thinks stocks should be rising. That is what happened at the start of 2010, as the Dow rose 4% in the two months before companies started reporting fourth-quarter results.

Companies more than delivered on investors' hopes, with three-quarters of the companies in the Standard & Poor's 500-stock index surpassing analysts' profit expectations. Instead of celebrating, stocks peaked on Jan. 19, just one week into earnings season. By Feb. 8, the Dow was 7% below its level of Jan. 12, the start of the fourth-quarter earnings season, as investors took profits. They also worried about Greece's national debt, an issue that flared again last week.

This time, despite the recent pause as the Dow approached the 11000 level, the market's gains have been even larger as earnings reports near. As a result, some analysts are sending cautionary notes to clients.

Among them is Justin Walters of Bespoke Investment Group. "We believe the market is more likely to struggle early on in the earnings season than make a big move higher," Mr. Walters wrote to clients last week.

In periods of earnings optimism, it is common for stocks to rise before profit reports and then fall when reports actually arrive, says Nicholas Bohnsack of Strategas Research Partners, who has studied the phenomenon. Mr. Bohnsack measures expectations by tracking what analysts call earnings preannouncements: firms' news releases about their own coming earnings. His conclusion is the same as Mr. Walters's: Stocks could face headwinds now.

Companies typically make preannouncements to warn of a coming disappointment, trying to avoid surprising investors or being accused of hiding bad news. In the last two decades, negative preannouncements have outnumbered positive ones by about 2.2 to one, according to Strategas. This time, the ratio is running at only about 1.3, far below the norm, according to Thomson Reuters, which has left investors upbeat. Companies including Aetna Inc., Texas Instruments Inc. and Family Dollar Stores Inc. announced in March that their quarterly results would come in stronger than analysts had expected.

In periods like the current one, when expectations are high and the preannouncement ratio is low, stocks tend to rise ahead of the reports and then fall once earnings reports are released, Mr. Bohnsack has found. The average decline is 1% during the quarter's first month, when the majority of earnings news is released. When the preannouncement ratio is high and expectations are low, stocks rise an average of 2.1% during the new quarter's first month, reacting positively to the earnings reports. "We have found time and time again that when the preannouncement ratio is less than the long-term average of 2.2, the market tends to sell off during the earnings season," Mr. Bohnsack says. This time, "we aren't saying the market's run is over, but it could get a little sloppy" during earnings season.

Analysts' earnings forecasts also suggest optimism is running even higher now than three months ago. In last year's fourth quarter, companies in the S&P 500 posted 17% profit gains overall, according to Thomson Reuters. That excludes financial companies, whose gains were skewed that quarter because many had posted losses or tiny profits a year earlier. For the quarter that just ended, analysts are forecasting 27% gains, again excluding financial companies. Including financial companies, the forecast is 37%.

"Earnings expectations are high enough to make it just too hard for a lot of companies to live up to them," worries Bespoke's Mr. Walters.

The average quarterly earnings gain, going back to the 1970s, is just 7%, so these expectations are well above average. (Thomson Reuters measures "operating" earnings, which don't include what analysts consider one-time items.)

Similarly high earnings expectations continue for every quarter through the end of the year, Thomson Reuters says.

What's more, the lesson from the last round of earnings was that even when companies exceeded expectations, as the majority did, they were often punished. Part of the reason is that stocks again are trading on what investors call whisper numbers, meaning investors are betting companies will do substantially better than analysts project.

In that situation, it may not be enough for a company merely to exceed analysts' numbers. To truly surprise investors, it must beat the numbers by a lot.

Moreover, investors expect companies to beat more than just the overall profit number. They want the company to do better than expected in key market segments, to maintain or improve its profit margin and to show sales gains, not just profit gains from cost-cutting.

In the fourth quarter, sales for S&P 500 members rose less than 8%. This time, analysts are projecting nearly 10% gains, and investors may be betting on more than that. Some investors note that, back in the January earnings season, other issues contributed to the market pullback. Investors were notably worried about Greece's solvency.

While that issue has reappeared recently, some people believe investors are turning strongly optimistic now and will welcome earnings news, sending stocks still higher during earnings season. "Earnings season has historically been good for stocks, except for the last quarter when everyone was obsessed over Greece," says Jack Ablin, chief investment officer at Harris Private Bank in Chicago. "This earnings season could provide another boost for stocks."

Stocks broke out of the doldrums after the last earnings season mainly because interest rates stayed low, helping keep plenty of cheap money in investors' hands, and economic news provided more evidence that the recession is over.

Now, expectations have risen steadily for both the economy and earnings, leaving investors focused on how much longer the Federal Reserve can maintain its promise to keep rates low "for an extended period."