The Corporate Earnings Conundrum

Today we start with a couple charts. One from Bloomberg: 

And one from research firm FactSet: 

Yeah, I’m a chart nerd, a real data geek. So I hope you can forgive me for getting all technical with you on a Monday afternoon. But this is fascinating stuff. 

It’s one of the worst kept secrets in the world of finance: analysts are always wrong. Even though they get an amazing amount of access to companies in order to gauge how the businesses are doing and offer up estimates for where quarterly earnings numbers will be, they pretty much never get it right. In part, that’s because estimating earnings is a game of cat and mouse with companies…

Virtually all companies offer earnings guidance. They’re happy to tell analysts where they expect revenue and earnings to be over the next 12 months. Most times, they are lying. And it’s because no investor wants to see a company they are invested in simply match the estimates they provide. Investors want companies to beat the estimates. Because beating expectations is the only way companies get more valuable.

Think about it: when you buy a stock, don’t you do so on the assumption that there is some reason the company will do better than what most people think? Like, if you buy a gold stock, you’re saying that you think gold prices will go up and the company will make more money. Or if you buy Starbucks, you’re thinking it will sell more coffee (though the real reason to buy Starbucks is food sales). 

So, companies always lowball their revenue and earnings guidance so they can beat the numbers and show everyone how great they are. And it’s the analysts’ job to figure out what’s really going to happen. Despite what some people will tell you, predicting the future is not an exact science. It’s more like educated guesswork. 

Eternal Optimists 

The first chart shows you how “predicting the future” usually goes. Analysts tend to be pretty optimistic. At the start of a given year, their earnings estimates are usually about 10% too high. They typically spend the first few months of the year lowering those estimates. And as that chart shows, the downward revisions have tended to hit a crescendo in May. 

Why May? I have no idea. But it explains some things. Like why we often see a sell-off in May, even if it doesn’t run into the proverbial “Sell in May” thing. 

It also explains why we often see a sell-off in January. That’s when the downward revisions start. 

This year has been no different for the analysts. They’ve been quietly lowering their 2017 earnings estimates for the last few months. But this year has been very different in one important way: first-quarter earnings have come in so good that analysts are now raising their estimates for the full year. 

Overall, Bloomberg says, “79% of companies have exceeded profit estimates and 66% beat on sales.”

These are the best beat rates in two years. And it gets better…

Just three weeks ago, analysts were saying that earnings for the companies of the S&P 500 would rise 9% from last year. (In case you forgot, up until the middle of last year, earnings had been falling for 15 straight quarters. So we are looking at a third consecutive quarter of earnings growth.) But as of today, S&P 500 earnings are on pace to grow 12.5%. 

And it’s not just earnings. That second chart shows you revenue is also beating expectations by a significant margin. 

Now, maybe you saw the first-quarter GDP number that came out on Friday. It wasn’t as bad as the 0.25% growth estimate that the Atlanta Fed was predicting. But at 0.7%, it sure wasn’t good. And it begs two questions: if U.S. growth is so weak, how in the world are corporate earnings doing so well? And what happened to the 3.5% growth we saw in the fourth quarter? 

To answer the first question — I can’t believe I’m going to say this — it seems to be because global growth is doing better than expected. U.S.-centric companies have posted 9% earnings growth, while the big multinationals are growing earnings at a 19% clip. Crazy, right?

I took over as editor of The Wealth Advisory in early 2012. The first thing I did was declare The Wealth Advisory a U.S.-investment-only zone, and the second thing I did was recommend Bank of America at $9 a share. Nobody would be more surprised to see global growth pick up than me.

What’s Wrong With the U.S. Economy? 

Let me very clear about this: I am not abandoning my “U.S. stocks only” stance after one quarter’s worth of anecdotal evidence that the global economy is improving. I’ve been around too long and seen too many false starts to get sucked in so quickly. (Honestly, I hope I’m wrong and the global economy really is picking up.)

What’s wrong with the U.S. economy is debt. No, not federal debt. Though that is a problem, it doesn’t prevent the government spending. As much as politicians like to talk about a budget, the government doesn’t actually stick to any budget. It spends what it wants, when it wants. 

Of course, you and I can’t operate like that. We don’t get unlimited credit. If we spend too much, we have to cut back on some things in order to pay off others. And right now, that’s starting to happen more and more. 

Capital One (NYSE: COF) reported earnings last week. It wasn’t good. Capital One disclosed that the money it sets aside for bad credit card debt rose 29% in the quarter, to $1.7 billion. Capital One said its write-off rate for credit card debt rose to 5% — the worst rate in six years. 

Two other credit card companies — Discover and Synchrony — reported a rise in their write-off rate, too. 

This fits with what we’ve been seeing for the U.S. economy lately. The average American is stretched a little thin. Years of virtually nonexistent wage growth may be starting to catch up with us. 

With any luck, the strength of America’s companies will translate into more investment, higher wages, and accelerating growth instead of share buybacks. That would sure be a nice change.

Until next time,

Briton Ryle

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.