VERSACE: Expectations game plays out in quarterly reports

ANALYSIS/OPINION:

Earlier this week I received an email from a Washington Times reader asking, “With a number of companies set to report their full year 2011 results in the next few weeks and Europe back in the news, what are you watching out for in the marketplace?”

Great question, particularly since there are a number of things that have happened this week from a stock market perspective. But lets start with the first part of this readers question — corporate earnings reports, which formally began coming out last week but kicked into gear late this week. So far, the results for those companies that have reported fourth quarter and full year numbers have been so-so, with some companies reporting in-line results, some beating and some missing Wall Street analyst expectations.

Now, beating expectations is not a new thing, in fact if anything it has become less and less of a surprise over time. Perhaps the one sector that best showcases this is the financial sector, which saw misses just this week from Bank of New York Mellon, State Street, PNC Financial, and others, but O.K. or better results and/or outlooks from Goldman Sachs Group, Wells Fargo, and others.

According to Bianco Research, 68 percent of the companies in the S&P 500 earned more than the consensus, or median, forecast by analysts in the first quarter of 2011. Whats interesting about that quarter was it marked the ninth in a row in which at least 2/3 of the companies in the S&P generated positive surprises. That same quarter also was the 50th consecutive quarter in which at least half of the companies surpassed the consensus forecast of their earnings. Keep in mind that this is a four-year period that included the depths of the financial crisis. Even at the recession’s depths, according to Wharton Research Data Services, between 59 percent and 66 percent of companies beat expectations between the third quarter of 2008 to the first quarter of 2009. For the most recently-reported quarter — third quarter of 2011 — roughly 70 percent of S&P 500 companies reported earnings that exceeded analysts’ expectations.

I suspect after reading those statistics there are a number of questions jumping out at you. The one that weighed on me is “what would happen should the pace of those earnings beats begin to fall?” Here’s why - for the current earnings season, only about 47 percent of companies that have released their December quarter results so far have beaten Wall Street expectations. Granted, we will be hip-deep in earnings reports over the next few weeks, but we also have to remember that through the end of 2011, 96 companies in the Standard & Poor’s 500 index revised their fourth-quarter guidance downward, the largest number since 2001.

That has led to several downward revisions in the aggregated earnings-per-share forecasts for the S&P 500 companies in recent weeks and continues the downward slide in 2012 expectations since August. Currently, the Street is calling for just under 6 percent earnings growth for the S&P 500 this year compared to last year, which is down sharply from the 17 percent forecasted this past August. That latest revision is less than half the rate of earnings growth for the index in 2011 and less than the 9.2 percent earnings growth the S&P 500 has averaged over the 2002-2011 period.

Yet despite that analysis, the S&P 500 is up 4 percent year to date as I write this, which we can attribute to a number of favorable rearview-facing economic statistics released thus far in January. What lies ahead is Europe, its debt crisis and the potential ripple effect. Those concerns led the World Bank this week to cut its forecast of world economic growth to 2.5 percent in 2012 and 3.1 percent in 2013, well below the 3.6 percent growth for each year it projected in June.

Will forward expectations have to catch up or will S&P earnings expectations pull through and drive a relief rally like we saw last August?

Stay tuned.

• Chris Versace, the Thematic Investor, is director of research at Think 20/20, an independent equity-research and corporate-access firm in the Washington, D.C., area. He can be reached at cversace@washingtontimes.com. Follow him on Twitter @ChrisJVersace. At the time of publication, Mr. Versace had no positions in companies mentioned; however, positions can change.