How to Beat Wall Street’s Sleight-of-Hand
A new earnings season has begun, which is an opportune time for me to lift the lid on Wall Street’s quarterly con job.
Corporate managers commonly low-ball profit forecasts, so they can more easily beat estimates and get a boost in share prices. Below, I explain how this sleight-of-hand works. I also steer you toward a way to make money from the market’s shenanigans.
The big banks were the first to report third-quarter earnings on Tuesday before the opening bell and their results initially cheered investors.
However, stocks declined later in the day and closed lower as COVID-19 fears rose and vaccine hopes waned. The Dow Jones Industrial Average fell 157.71 points (-0.55%), the S&P 500 shed 22.29 points (-0.63%), and the tech-heavy NASDAQ sank 12.36 points (-0.10%).
Stock futures Wednesday morning were trading higher. Markets have been volatile in recent days, as equities bounce up and down based on mercurial investor emotions over fiscal stimulus, pandemic conditions and political rancor.
Eli Lilly (NYSE: LLY) announced Tuesday that the Phase III trial of its monoclonal antibody treatment for the coronavirus was halted by U.S. health regulators because of safety concerns. Investors were disappointed but if you’ve been reading my daily Mind Over Markets column, you weren’t surprised at all.
That said, the financial services sector yesterday and today provided upbeat earnings news.
JPMorgan Chase (NYSE: JPM) on Tuesday posted earnings that beat analysts’ estimates for the top and bottom lines. JPM posted third-quarter profit of $9.4 billion, or earnings per share (EPS) of $2.92, exceeding the EPS of $2.23 expected by analysts. The bank generated revenue of $29.9 billion, about $1.5 billion more than what analysts had expected.
Citigroup (NYSE: C) also reported better-than-expected results Tuesday for the third quarter. EPS came in at $1.40, versus EPS of 93 cents as expected. Revenue came in at $17.3 billion compared to the expected $17.2 billion.
For both banks during the coronavirus pandemic, credit costs stabilized and deposits increased. The banks also reported increased profits from their trading divisions.
Before the opening bell Wednesday, Goldman Sachs (NYSE: GS) posted third-quarter results that blew past analysts’ profit estimates on better-than-expected results in trading and asset management. The investment bank posted $3.62 billion in profit, or EPS of $9.68, surpassing expectations of $5.57. Revenue of $10.7 billion beat the estimate by more than $1 billion.
The rigged game…
As surprisingly sanguine Q3 earnings results come pouring in, it appears that many S&P 500 companies have been overstating their coronavirus-related hardships. These earnings reports seem impressive, but don’t get duped by the expectations game.
A company “wins” the game and enjoys a higher share price by posting unexpectedly positive numbers. But winning the game isn’t much use in predicting a company’s future competitiveness and cash flows.
Stocks have risen in the wake of better-than-expected second quarter 2020 earnings. On the basis of Q2’s performance during the pandemic recession, analysts are optimistic about the Q3 earnings season.
According to FactSet, analysts during the third quarter boosted earnings estimates by 4.1% for S&P 500 companies for the quarter. “Bottom-up” is an aggregation of the median EPS estimates for Q3 for all the companies in the index (see chart):
But some historical context is called for. When meeting with analysts to discuss forthcoming earnings reports, top management often downplays how well the company has done. It’s akin to keeping an ace up their sleeve. They know the stock price tends to increase if they beat artificially low expectations. The result? Overpriced shares that are vulnerable to a tumble.
According to a classic study conducted by the Harvard Business Review:
“Good earnings news can light a fire under a company’s stock, but if the company misses its number by even a penny, its stock is likely to get hammered. And many, if not most, senior executives have compensation packages tied to stock-price and earnings targets.
Both the paychecks and the reputations of securities analysts depend on accurately forecasting the quarterly earnings of the companies they cover. Investors, or at least traders, profit by correctly divining which companies will meet or exceed expectations and which will fall short. As for accounting firms, if they help a company meet its numbers—sometimes by ignoring, or even suggesting, some pretty dubious bits of bookkeeping legerdemain—then they can usually count on retaining the company’s lucrative auditing business and maybe pick up a consulting contract as well.”
The Harvard Business Review, an objective and widely respected academic source, has thrown a spotlight on Wall Street’s rigged earnings expectation game. Do you want to tilt the odds back in your favor?
Consider the investment advice of my colleague Jim Pearce. A veteran trader with decades of profitable trades under his belt, Jim is ready to reveal his trading system that makes money from the market’s imbalances. He knows how to pinpoint overvalued stocks and harvest a windfall from their day of reckoning.
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