Rambings of a Portfolio Manager

Lesson’s from earnings season

Fourth quarter 2009 earnings reporting season is winding down and so far, with 84% of S&P 500 companies reporting, the results have been fairly impressive. According to Thomson Reuters, of the companies that have reported 72% have beaten earnings expectations, 10% met expectations and 18% missed. This result is much better than the historical average of 60% beating analyst’s estimates. Revenues, which have consistently underperformed expectations coming out of 2008’s massive decline, actually surpassed expectations with 71%of companies beating and 29% missing estimates (no revenue reports matched expectations but, of course, that’s somewhat spurious as companies manage to EPS but revenues are harder to manipulate). Earnings growth year-over-year was a whopping 212%, but that was off a very low, recessionary base. Still, for all of 2010, earnings are expected to rise 27% from 2009 levels. All of this positive news, however, was greeted in most cases by selling. Why?

As usual, Alcoa kicked off earnings season with its report, the first of the Dow components to do so. Expectations were high for the company, given what the stock and the price of its underlying commodity had done since the March lows. While Alcoa’s revenues beat expectations investors, however, were disappointed as Alcoa delivered weaker than expected earnings and guidance due to higher costs, something that has not been an issue for reporting companies since Q4 2008. This put the Market on edge and set the stage for a round of “sell on the news” reactions to all future earnings reports, both good and bad. If Alco set the stage, Intel’s report was the catalyst for this trend as the company’s much better than expected report and guidance was greeted with a 3% stock decline and after Intel, the stock of virtually every other reporting company suffered the same fate. Had the whisper numbers (i.e. expectations) gotten ahead of underlying fundamentals? Did the market come too far too fast, as many disgruntled bears claimed? Actually, we believe that some really bad timing on the calendar had much to do with the price action seen during the past reporting season. First, we are into a new year, meaning that funds with big profits in positions from the March lows were more willing to sell and book a taxable gain than they were at the end of last year. The fact that the Bush capital gains tax cuts are due to expire at the end of this year certainly exacerbated this behavior. Secondly, there was the Scott Brown election, the results of which we received two days before Intel reported. President Obama’s attack on the banks, launched the next day in response to that defeat in Massachusetts, put a market already nervous from Alcoa’s report further on edge and started new talk about a potential government-induced double dip recession. The final straw was China’s mandate to its major banks to curb lending, released concurrent with Obama’s speech, which further raised concerns of a double-dip based on a slowing China, if not a business unfriendly US government. Timing is everything and in late January we got a confluence of unfortunately bad news.

Frankly, we’re not concerned by the price action following recent earnings reports and view this as a temporary, short-term trend. Gains that were taken in January and early February are now booked and remaining holders seem to be comfortable waiting for long-term capital gains status. Already we see that the Market is pricing in the risks of China’s actions and Obama, perhaps in reaction to the polls, is looking very much like he is moving toward the center ala Bill Clinton. The combination of the above is probably the reason for the Market’s rally since February 8th. As earnings and economic data continue to come in better than expected, we see a moderation and reversal of the sell on the earnings news trend. If that’s the case, then the Market may be ready to continue its move higher over the next quarter.