The Truth about Earnings Reports

After news about interest rates, corporate earnings reporting is the fuel that turns the wheels of the stock market.

Good earnings mean high profits, high profits mean substantial returns on investment dollars and great returns mean price increases, growth and raging bulls. With so much riding on earnings, you would think that Wall Street analysts and professionals would use the information to properly advise clients and make money for them and for themselves.

But earnings forecasting is a crapshoot, only slightly better than an educated guess. It is based on supposition, assumption, rumor, telephone calls and instinct. The luck and courage of the forecaster are as much factors as his or her knowledge, insight and ability. Predict correctly and be a hero. Be wrong and watch your clientele flock to your competition.

This is a cutthroat game with high stakes. As a result, earnings forecasts tend to be unreliable. Here is why. The risk of being wrong is so great for the analyst that instead of striving to be correct, they will aim to be as close to the pack as possible, that is, as near as possible to the predictions of all of the other analysts. If they are wrong, they are all wrong together, and no one stands out.

In order for this to happen, all of the analysts must have consensus without conspiracy. To do this, they will look at the previous earnings report and the prior earnings growth rate.

The contest thus revolves around which analyst can come closest to the true earnings while not straying too far from the past earnings. The easier to predict, the more likely the stock will be analyzed in the first place. In turn, the more analysts that follow a stock the more heavily traded it is, and the more popular with investors.

Disappointments and Pleasant Surprises

When the actual earnings reports do arrive, they are greeted without much fanfare. An earnings report "within Wall Street expectation" is a non-event. However, large deviations garner the labels "disappointing" or "surprising" or "above" or "below analysts' expectations." This is because, for the most part, all of the analysts were off.

All of this explains the immediate reaction of the market to earnings announcements. Because analysts' estimates are generally announced a significant time before actual earnings reports, by the time the earnings are issued, their results have already been factored into the stock price. Therefore, a huge rise or fall in earnings that are within expectations will not result in similarly large gains or losses in stock prices. Those gains or losses appeared as the forecasts were made, not when the actual reports were issued.

It is only when the "Wall Street analysts" are wrong, and actual earnings are above or below "Wall Street expectations," that the market reacts with large price movements. And often those price movements happen not only in the one company whose earnings are reported but also in that company's industry and sometimes even the market as a whole. That is because investors panic, thinking that if the expectations are off in one company, they may be off in others, and in the same direction.

True Wealth
That said, however, most market analysts are not stupid. Nor are they cowards. And that is why their profession is so stressful. What does an analyst do when his best information runs contrary to his colleagues and competition; when he has access to information that has eluded the others; or has a gut feeling that bucks the trend? Does he take the conservative route and only slightly deviate from the pack? Or does he bite the bullet and give it his do-or-die best? Or does he play a middle ground and keep his true prediction for only a "select" group of investors?

It's a difficult choice. The rewards are great and the consequences dire. Many millions of dollars could be riding on his "expertise." Not all react the same way.

That is why my best advice is:
  • Do not buy or sell on earnings forecasts.
  • Do not overreact to earnings reports when they come out.
  • Do not believe everything you read or hear; very few people really know.
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