The Bad News Buried in Positive Earnings Surprises
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The Fiscal Times
July 19, 2012

Is the stock market finally recovering from its months-long swoon? On the surface, at least, it seems so: In trading yesterday, a nine-point gain in the S&P 500 was enough to propel the bellwether index to 1,372.78, the highest level recorded since early May.

The timing here is interesting, though. When the market faltered in May, it was just as the first-quarter earnings season was beginning to draw to a close; this week, the second-quarter earnings season is getting underway in earnest, with blue-chip companies like the big banks, Intel (INTC) and Honeywell (HON) reporting their results. For now, at least, investors are prepared to view those results through rose-tinted glasses, looking at the positive news and responding with a kind of relief rally. Perhaps they have been left exhausted by their own bearishness of late or perhaps they really do believe these corporate earnings announcements paint an upbeat picture of the fundamentals for the global economy.

But regardless of the market response, many of these earnings results offer little reason for wholehearted enthusiasm. There have been many positive surprises, that’s true – but in many cases, these are only “positive” either because analysts have spent the last few months trimming their expectations or because the company has been downplaying its own forecasts.

So, for instance, the earnings of $1.78 reported by Goldman Sachs (GS) on Tuesday was technically a positive surprise for the bank – analysts surveyed by Thomson Reuters had expected the figure would be close to $1.16 a share. That news helped push Goldman’s shares higher immediately after the announcement. But that figure is still below the $1.85 a share Goldman reported earning in the second quarter of 2011, and the company’s return on equity is half of what it was then and less than a third of its former target. Not surprisingly, Goldman’s stock, which traded at $99 immediately after the earnings news, now changes hands for about $97.

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Look around and there are plenty of other mixed signals being sent by companies as they report earnings. Take Intel, which announced earnings (before one-time items) of 57 cents a share, above the anticipated 52 cents a share – and higher revenues, to boot. The stock jumped 3.3 percent during trading on Wednesday. But there’s a cloud attached to that silver lining: Intel revised its future growth projections lower, saying it now expects to see revenues climb only between 3 percent and 5 percent rather than the high single-digit gains it had previously expected.

Over at another technology giant, IBM (IBM), investors responded positively to news of the company’s gain in earnings, which rose from $3.30 a share to $3.34 a share, while operating earnings were $3.51, beating the consensus forecast of $3.42. But the company’s revenues shrank for the fourth straight quarter, as did its costs – a sign that the company’s growth in earnings is coming more from cost cutting than organic growth. At least it raised its earnings forecast for the year.

Then there is Bank of America (BAC). The bank’s $18 billion settlement of its mortgage mess in the second quarter of 2011 depressed its earnings for that period so much that it makes its just-reported earnings for the second quarter of 2012 look like they have soared into the stratosphere. Indeed, the impact of that one-time charge is so large that it is distorting the impact of earnings growth predictions for the S&P 500 as a whole, as we’ve noted before.

After announcing a loss of 90 cents a share in last year’s second quarter, the bank announced a profit of 19 cents a share for the quarter this year. That’s better than the consensus estimates of 14 cents – but again, the good news was accompanied by bad. In this case, Bank of America must grapple with the impact of low interest rates on its business – net interest income is plunging – as well as a slump in revenues across almost all parts of that business. Ultimately, it didn’t seem to matter much to investors that the bank had posted a positive surprise: The stock lost nearly 5 percent in trading yesterday.

Let’s face the harsh truth: An earnings surprise simply isn’t what it used to be. For a positive earnings surprise to be unmitigated good news for a company, it must:

1. Be a real surprise – in other words, the profits must be higher than estimated three to six months ago, not just a few pennies above the most recent consensus estimate reached after analysts have spent weeks busily cutting back their forecasts.

2. It needs to be across-the-board good news; there can’t be major signs of weakness in one part of the business, or a decline in revenues.

3. The results must demonstrate that the company’s earnings have grown, not just done better than anticipated.

4. The company can’t accompany good current earnings news with a downward revision of forecasts for the coming quarter or two; while the CEO doesn’t need to being exuberantly bullish, he or she can’t openly warn of tough times to come.

5. There can’t be any background noise or anxiety, whether on a company or industry basis, or from macro events like the ever-rumbling European debt crisis.

In an environment that remains volatile and uncertain, investors will reserve the right to respond unpredictably to whatever “positive surprise” is announced tomorrow. The market may have retraced a lot of the ground forfeited in recent months – but it may not take much for these gains to evaporate. Earnings season provides investors with real data points, but just as any bullishness created last spring vanished when earnings season ended, there’s no reason to believe that pattern won’t repeat itself this summer.

Business journalist Suzanne McGee spent more than 13 years at The Wall Street Journal before turning to freelance writing. Author of the book Chasing Goldman Sachs, she has written for Barron’s, The Financial Times, and Institutional Investor.