Basic rules for playing the earnings game

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”.

Fair point, but until then, traders are right to buy the dips. Every pullback over the last 18 months has ended with Vix readings in or around the 20 level. Betting against volatility has been the profitable move.

Rich valuations no concern Investors looking to guard against market declines tend to rotate into low-volatility stocks.

But do such stocks offer protection if they are richly valued, as they are today?

Alliance Bernstein notes that low-volatility stocks outperform in more than 80 per cent of down months for equities. However, they now trade at a 19 per cent premium to the MSCI World Index, well above historical norms.

Interestingly, it doesn’t matter. Even when richly valued over the last 25 years, such stocks continued to outperform in down months. In fact, over both three- and six-month periods, they did even better than when they were cheaper, outperforming world indices 96 per cent of the time in the latter case.

Investors, it seems, are attracted to defensive stocks for reasons other than valuation.

Stocks with less sensitivity to the economic cycle have inherent appeal in jittery markets, says Alliance Bernstein, especially ones rocked by changes in growth or interest rate expectations.

Accordingly, current valuations are unlikely to deter investors in the event of an outbreak of market nerves.

High flyers have had their day Momentum stocks, pounded since March, recovered some ground last week. However, while valuations may be nowhere near as forbidding, a recent Goldman Sachs note suggests the high flyers have had their day. Following such selloffs, it says, stocks characterised by low momentum, low valuation and low growth tend to outperform over the following six months. Similarly, stocks with the highest enterprise value-to-sales ratios tend to underperform over the following one-, three- and five-year periods, "regardless of the sales growth that is actually delivered".

Momentum is a powerful force in markets, but when it’s gone, Goldman cautions, it’s gone.

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Better-educated employees don’t have a telepathic understanding of market direction, but they do hold 11.5 per cent more equities in their portfolio, the authors found. That means more volatility, but a pension pot some 25 per cent more than their less knowledgeable counterparts. The paper can be purchased at http://goo.gl/NTIQLU.