Do all the earnings warnings mean it's time to buy?

Even though these alarms are on the rise, they have helped control growth expectations to a level the market can digest.

By Zacks.com Jan 17, 2014 4:18PM

Dice on stock listings © Kate Kunz/CorbisBy Jared Levy 

 

I think it's safe to say that Quantitative Easing is considered a market crutch by many. But now that we know it's coming to an end, why aren't stocks crashing? Could this market actually support itself without the Fed? Perhaps.


Headlines can be scary. Think about the events that took place in 2013. We went "over" the fiscal cliff, hiked taxes on Americans, and began making automatic budget cuts via the sequestration; heck, we even shut down the government for more than two weeks!


Then the Federal Reserve's Federal Open Market Committee announced a reduction in monthly bond purchases sooner than later, meaning that $90 billion (now $80 billion) in monthly bond buying will just go away. . . and yet stocks are not only holding their ground, but moving higher.


What's even more fascinating (and somewhat scary) is that fourth-quarter earnings growth estimates have not only dropped to 6 percent from close to 12 percent just three months ago, but earnings warnings are at an all-time high.

 

Wall of worry?

Yes, earnings warnings are at an all-time high. In fact, 88 percent of the companies on the S&P 500 that have issued an earnings outlook for the fourth quarter have been below Wall Street consensus estimates.


Prior to the start of fourth-quarter earnings season, 108 companies had given earnings outlooks that fell below the Wall Street consensus, compared with 11 companies that gave an in-line figure and 11 companies that provided an estimate above the consensus.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Should you be concerned?

Over the last four years, you've heard many (including me) gripe about the lack of a true economic comeback, but maybe it's better that we don't have an immediate resurgence in economic activity. Perhaps this moderate, almost pathetic recovery will keep major bubbles from forming amidst the FOMC's cheap (free) money policies.


The truth is that earnings warnings have been on the rise, but they have helped control growth expectations to a level that the market can digest, rather than force it to have to deal with earnings report shocks that could have caused severe volatility and doubts in true sentiment.


I actually see this chart as bullish because despite the almost 100 percent increase in corporate warnings over the last four years, the S&P has managed to tack on an 80 percent return. Think what would happen if Wall Street just let growth expectations run amok! If the majority of market participants were expecting record breaking growth, negative surprises would not only have dramatic negative effects on stock prices, but also on the psyche of the average investor.


So I say warn on! Just as the FOMC has successfully managed expectations and kept us in the loop about its progress and scaling of quantitative easing, corporate America should minimize surprises and help keep copious amounts of exuberance and gloominess controlled.

 

Psychological state of things

Despite the drawbacks and reductions in estimates, the S&P 500 has managed to gain over 26 percent in the last year.


Why? Because there is not only value left in many stocks, but the underlying hope (bullishness) remains. Moreover is the fact that the U.S. is still the best place for global investors looking for a place to park their hard-earned dollars, and investors are even looking beyond QE to see bullish potential.

 

If markets were completely euphoric and irrational, then we should have seen a 10 percent to 15 percent correction without a bounce after the FOMC's decision to taper.


There are 14 stages of investor sentiment; these variations can be fairly easy to spot at times and elusive at others. Stocks often trend depending upon the psyche of investors, not always on hard fundamental data.

 

Interestingly enough, there is clarity amidst the chaos. As we entered into the New Year, there was doubt and markets were cautious, but stocks still managed to charge forward.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

"Hope" was the best way to describe the marketplace back in January 2013, which was fairly close to the point of maximum profitability in the market's emotional cycle (see the chart above).


If we take a look back to mid September 2012, markets were completely euphoric running up to the elections, with the fiscal cliff just a twinkle in the eye of only the savviest investors. After the election results and woes about the cliff and future of the economy, the market quickly gave back 9 percent, changing the mood from elation to outright depression.


Over the last year, we have watched market sentiment go from a state of panic and then completely turn around.


Towards the end of 2013, stocks had run up into the "thrill zone", but took a break, gathered some rationale and reset themselves back into what seems to be more optimism than anything.


By setting very realistic expectations, the market is doing an excellent job at controlling our emotional roller-coaster.

 

Managing earnings expectations

While emotions can rule the markets much of the time, there are four times a year when stocks report their results (earnings) and the objective overtakes the subjective. If the subjective mood is not "overly euphoric" than stable objective data should cause stocks to rise; this works in the opposite direction as well of course.


The good news is that markets are not euphoric or even overly optimistic when it comes to most earnings expectations. In fact, stocks are perhaps more realistic now than at any other time this year, but you must be able to identify those stocks that have built up such a high expectation that it may be impossible to deliver.


I'd be lying to you if I said that corporate revenues are shooting up and that the average company is making money hand over fist. But I can say that there are three things that I (still) feel very good about in the first half of 2014:


1. Corporations are lean and mean. The average American company has cut costs and economized its businesses to keep margins high and operate in a low-growth environment. Margins are still expected to be on the rise year over year.


2. Hoards of cash. We are seeing many companies stockpile cash and equivalents, preparing themselves not just for the worst, but for the turn. The turn being an improvement in the economy and post QE prosperity; that cash is utilized for expansion, M&A, share buybacks and dividends.


3. Expectations are low. As I mentioned last quarter, expectations were relatively low, but more recently the average share price and growth estimates have come down even further. This makes the reaction to a positive surprise that much more significant.


These factors will help support the markets throughout the coming earnings season, as long as revenues do not fail miserably.

 

How do you trade earnings?

Expectations are low for a reason. I wouldn't expect the overall market to see as good a return in 2014 as we saw over the last year. Many analysts are also predicting a pullback in the near term.


This means that you have to be laser-focused and step outside the box to find alternative investment methods that capture superior returns. Defensive stocks and utilities are not in vogue and even stocks with low multiples aren't going to necessarily be safe havens if their reports are weak. Not all stocks are rising in this bullish market.


To get the edge, I target and study analysts' behaviors and actions ahead of a report to sniff out those companies most likely to beat earnings expectations. I compound that data with relative valuation and sector favorability to find high stocks with a high chance of not only beating estimates, but moving higher on that news.


The perfect way to add this type of diversity to your portfolio is to target companies likely to beat analysts' estimates and keep the trades short in duration so you won't be over-exposed to a market that is still susceptible to headlines.


The bottom line is that we will still have companies that perform extraordinarily well and top analyst expectations this coming earnings season. These companies will see their share prices break away (positively) from the market average as they attract new money looking for yield.


You will need an effective tool to do this; one that stacks the odds in your favor. Whatever method you choose, be sure to allocate your assets appropriately, reduce risk where needed and take or protect profits once you have them. This will certainly be a tough quarter for the average "long only" investor.

 

Listen to the right whispers

I am directing a service that uses Zacks research data to predict positive earnings surprises before they're reported. It has greater than 82 percent accuracy in selecting companies that beat estimates. Although these "surprise" stocks don't all turn out to be winners, listening to selected whispers obviously can give investors a substantial advantage. So if you would like my specific stock recommendations, they are available today in the Zacks Whisper Trader.

 

But please note that to be fair to our current members we can't allow too many traders to share these stocks. So the portfolio will close to new investors Saturday, Jan. 18.

Learn more about Zacks Whisper Trader 

 
Happy Trading (and don't forget to hedge),

Jared


9Comments
Jan 17, 2014 6:33PM
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Sum up all of this rhetoric:  "... fourth-quarter earnings growth estimates have not only dropped to 6 percent from close to 12 percent just three months ago, but earnings warnings are at an all-time high."

... 

"...88 percent of the companies on the S&P 500 that have issued an earnings outlook for the fourth quarter have been below Wall Street consensus estimates."

Jan 17, 2014 7:41PM
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if not for 401 k money put in every other tuesday the markets have no real momentum.....the longer the smart money keeps pecking away at the top the more of the top they can get..and cnbc will preach buy the dips buy the snp ..tell us why 401 k tuesday is always records.n why smart money dumps 1 % on monday to make room for it....mom n pop r all we need to fleece now to get to a market top.. come on mom i want to short this thing
Jan 20, 2014 5:47AM
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It's time to buy when the asset value, durable competitive advantage, growth prospects and dividend of the company strongly suggest you'll get a decent return on your money.  NO ONE knows what the market itself will do and basing buying/selling on what someone guesses it will do is no better than buying/selling because the Moon is in the 7th House and Jupiter aligns with Mars.

Jan 17, 2014 6:49PM
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Prepare for sideways action.  You can not get another 25% mover after a 25 % year and with PEs at the historic side of normal/high.  Could have a correction, not a cash, and could trade sideways with an upside 5% bias.  However, this means to mean that froathy stocks are at risk.  It is now a stock pickers market.
Jan 20, 2014 1:12AM
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If you own $80,000 worth of stocks you might want to start selling $10,000 or more each time the FED tapers by $10 billion so your at $70,000 or less now.

Jan 19, 2014 10:35PM
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Is this author always so inflammatory?  First of all he never defines these "warnings".  It seems to me they simply company statements of a projected reality.  The non-company consensus estimate people got it wrong 88% of the time.  And they get paid well even when they prove how disconnected their estimates are from reality.

So there really are no warnings - so the estimators are useless - so the author is a well paid-by-the-word hack.  Am I being too harsh on this guy? 
Jan 18, 2014 12:10AM
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A future Republican in the making.

http://www.youtube.c​​​​​​​om/watch?v=Auk​E​2​5​i​s​p​VY

They are simply adorable and loving little things aren't they?
Jan 17, 2014 8:16PM
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No, all the earnings warnings mean the Dow and S&P are over priced by about 10-15% and that will be corrected when the "sell in May and go away" crowd starts chanting in about 3 weeks time.
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