Those of us who are paid to pay attention to what’s going on in financial markets have had a number of distractions recently—the ongoing “crisis,” if that’s the word, over Greece and other countries on the periphery of the European Union, and whether or not any of them will default (probably no); the question of whether many of the millions of jobs lost to the current recession in America and Europe are likely to come back (probably no); whether Peyton Manning is the greatest quarterback of all time (probably no, and who cares?). But our main distraction these days is corporate earnings. That’s because we’re supposed to know whether companies are making or losing money, but even more importantly, whether or not they’re doing better or worse than Wall Street analysts say they’re going to do. That’s because what markets respond to is often not actual performance, but performance versus expectations. And an awful lot of the happy talk in the media about how we’re pulling out of the recession is based on the “fact” that corporate earnings are looking pretty good.
So what we—and the markets, particularly equity markets—really pay attention to is “beats” versus “misses.” Once you know the lingo, you can vary these with adjectives—a “solid beat,” a “whopping miss,” that sort of thing. And the financial press is full of this sort of language four times a year, since earnings reporting occurs quarterly in the US (and increasingly so in the UK and Europe, although we still have a number of companies that still report only twice a year). So every couple of months we all gird ourselves for the next round of reality versus illusion.
For example, we’re now generally in the middle of earnings reports for the fourth quarter (which usually ends on 31 December for most companies). And the headlines have generally been pretty positive. That is to say, there have been lots of headlines about how earnings have been generally better than expected. Now, we only get so many companies each day, but there’s usually a cumulative impact—on market psychology, on economic expectations, and on analyst bonuses. And we’re only about halfway through reporting in the US, but we’re mostly done here in Europe. Now, it turns out that Bloomberg has a handy little function (EA) that tracks surprises in terms of EPS, net income, and sales. So if we focus on EPS, what the market generally focuses on, here’s what it looks like in Europe:
So what this is telling us (in the right hand column—there’s lots of other interesting information here, too) is that positive EPS surprises (beats) exceed negative EPS surprises (misses) by about 1.1 times—probably within the standard of error (although I haven’t checked this) for this sort of series. This seems reasonable—we’ve had 533 public companies report, 171 of them beat, 155 of them missed, and the balance matched analyst predictions. Actually, let’s think about that for a second—taking out the beats and misses, only 207 of 533 companies matched analyst predictions—or about 39%. So 61% either beat or missed. Hmmm.
How about in the US? Well, actually, things look a bit different:
Because here we see that positive surprises exceed negative surprises by a factor of 2.3X. Whatever the standard of error, this probably exceeds it. This is a much larger set, of course, since the US has many more public companies than Europe does. Just as interesting, perhaps, is the fact that of the 2,181 companies that have reported, only 659 matched analyst expectations, or about 31%. This doesn’t seem like a particularly good track record, frankly. European analysts only get it right 40% of the time, not particularly impressive. But US analysts are even worse—they’ve gotten it right 30% of the time so far this season. In fact, of the 2,181 companies that have reported, 1,058 (about 49%) generated a positive earnings surprise. Which means that US analysts under-predicted earnings by a factor of about a half.
I’ve actually been following this for awhile; if we look at third quarter 2009 earnings, we see a similar pattern—US companies generated twice as many positive surprises to negative ones, or about 2X; and US analysts only accurately predicted EPS earnings less than half the time (which means that predictions for the current period are well below even this unimpressive number). For Q3 earnings in Europe, this ratio is about 1.3X, and European analysts accurately predicted EPS about 60% of the time. And if we go back to the previous quarter, we find a similar pattern. So, to the extent we can generalize, we can say the following: analysts following European companies do a better job of (1) predicting earnings in general, and (2) avoiding understating earnings in particular, than do their US counterparts. If anything, US analysts have a negative bias that their European counterparts do not have.
So maybe we have this the wrong way around. Because there are two ways to look at this phenomenon. The first is how I’ve just described it—companies do better or worse than analyst predictions. But we could just as easily flip this around and ask—how are analysts doing? Especially since the market seems to put a pretty high premium on what they’re thinking. And these people generally get paid a lot, a whole lot. Maybe the question should be did the analyst get his or her call right, rather than did the company beat or miss the analysts’ predictions? Because if we look at earnings reporting in this light, it’s pretty clear that US analysts have been consistently underestimating how US companies actually perform. And in this regard, we have to ask whether or not US analysts even deserve that paycheck—because their miss rate seems pretty high. And if these guys show that they can’t get it right, why should they be paid a lot of money? And why should we (specifically, the financial press) listen to them?
The answer to the first is easy—because they generate trades for their trading desks, which is where the money is. That seems straightforward. The answer to the second question is a bit trickier, and it’s that I have no idea. Mister Market continues to put an inordinate emphasis on surprises. But since the analysts themselves seem to be surprised most of the time, why they continue to get lots of press and to show up chatting with Maria Bartiromo on CNBC remains something of a mystery.
Now, I haven’t done a more detailed analysis of this, having neither the time nor the point to prove, but that’s what needs to be done here. It seems to me that some bright empiric in business school somewhere, one who presumably is looking for a nice academic post rather than an investment banking job, might pursue such an analysis. At least then we might have a better sense of what’s going on. Because right now we don’t. For US analysts in particular, we seem to have to choose among a range of unpalatable choices—(1) analysts aren’t very good at what they do, or are just plain stupid; (2) analysts are good at what they do (since most of them seem to keep their jobs), but we don’t really understand what it is they do, and they’ve fooled us up to now: (3) since companies know that a positive EPS surprise will boost their share price, companies are doing a very good job of going out of their way to fool analysts, and since analysts are generally dim, analysts keep falling for it; or (4) it’s all one grand capitalist conspiracy. Take your pick.