Basic rules for playing the earnings game

A trader works on the floor of the New York Stock Exchange recently: Europe has slightly outperformed the US this year. Photograph: Andrew Burton/Getty Images

A trader works on the floor of the New York Stock Exchange recently: Europe has slightly outperformed the US this year. Photograph: Andrew Burton/Getty Images

Tue, May 27, 2014, 01:05

When it comes to analysing earnings, it’s important to remember that everything is relative, and that expectations are everything. Europe has slightly outperformed the US this year, for example, despite the fact less than half of Stoxx 600 companies beat analyst estimates, compared to a beat rate of 75 per cent in the US.

Ultimately, the figures didn’t surprise investors. In Europe, overall earnings growth of 2.5 per cent satisfied investors, who are hopeful a corporate rebound is under way.

Their patience is not inexhaustible – one-day declines suffered by companies missing estimates by more than 5 per cent was double the average recorded over the last four years.

As for the US, investors understand the earnings game. Initially optimistic analysts keep lowering estimates, allowing companies to deliver an unsurprising earnings surprise (note that just 45 per cent of companies beat estimates that were set on December 31st).

The relative nature of the game is exemplified by the reaction to seemingly strong technology earnings. The tech sector was one of the strongest in terms of beating earnings and revenue expectations. However, tech stocks beating estimates saw an average one-day gain of just 0.45 per cent, according to Bespoke Investment Group, while those missing estimates suffered average one-day declines of 6.7 per cent.

Meeting or beating estimates tells you little. What’s crucial is whether it’s been priced in in advance. The death of volatility? The most striking feature of the equity bull market in recent years has been the utter lack of volatility, prompting market strategist Nicholas Colas to recently ask if we are “witnessing the death of volatility”.

Are investors “so accustomed to central bank intervention that any negative macro action has an equal and offsetting policy reaction”?

Volatility isn’t dead, but it is dormant, and that concerns Société Générale’s Andrew Lapthorne. There has not been a 10 per cent correction since 2012 (the fourth-longest period on record), he notes. The annualised peak-to-trough pullback has been just 5 per cent, compared with typical annual drawdowns of 15 per cent. Additionally, the Vix, or fear index, last week fell below 12, compared to its historical average of 20, and is on the verge of making a new low for the current cycle.

There is a “potentially risky build-up of investor complacency”, Lapthorne warns, with equities seen as “one-way upward plays”. This may draw in new investors without the capacity to withstand volatility, he warns; policymakers “should be more vocal about the potential downside”.

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