No Soup for You

Domestic equity markets have not performed well in October. Through Monday October 29, the S&P 500 Index is down 9.36%, and the smaller-capitalized Russell 2000 Index is down 12.92%, on a price return basis. These declines have occurred against the backdrop of what appears to be—at least on the surface—a strong third quarter earnings season. Year-over-year earnings growth is trending above 20% and the percentage of companies beating consensus estimates is above average. Companies with positive earnings surprises have not been immune to the October sell-off, however. In fact, quite the opposite as reactions to positive earnings surprises have actually been negative.

A recent 361 Capital Weekly Research Briefing mentioned this reaction. Citing FactSet data for the S&P 500, it showed responses to negative earnings surprises so far in Q3 have experienced an average decline of 3.5%. This is greater than the 2.5% average decline over the last five years. What’s even more striking is companies with above-consensus earnings have also seen their shares drop. Positive earnings surprises have declined 0.5% compared to an average increase of 1.0% over the past five years.[i]

Our own surprise earnings models (“SUE”) are providing similar information. A greater proportion of companies are beating estimates, although response rates have been sharply negative. This phenomenon has occurred in previous quarters, however the magnitude of negative responses has increased lately.

So, what is behind this? Several explanations could provide insight into the bearish sentiment considering strong earnings reports.

    • Beating consensus is not a differentiating factor in this environment. The percentage of companies reporting positive earnings surprises in our large cap universe has grown from just over 20% in 1996, to over 64% for the quarter ending September 30, 2018. Negative earnings surprises have declined, albeit at a slower rate, declining from 16% in 1996 to 10% last quarter. This positive-to-negative spread is the widest in our data history. Companies are beating consensus by more than one standard deviation at a rate that is four times what a normal distribution would indicate (the children of Lake Wobegon are getting exposed).
    • Absent positive guidance, anything less-than-stellar can quickly pivot from attractive to risky. Execution and outlooks must conform to high expectations. The market’s reaction to companies that have not met its stringent expectations is analogous to the famous Seinfeld character who punished customers for not ordering in a very precise way.
    • There is belief that we are near the peak of the earnings cycle, the bull market is long in the tooth, and fundamental risks are increasing, so anything that fits this narrative will increase conviction for investors looking to validate those feelings.
      “…the results have not been strong enough to push aside mounting investor fears—ranging across peak margins on higher input costs, the strong dollar, waning benefits from tax reform, decelerating China growth, potential destabilization from the Italy budget crisis, a weak housing market, trade-war fears, and worries about a possible policy mistake by the Fed.”[ii]
    • Barron’s stated that momentum selling was partly to blame. When stock prices appreciate prior to earnings announcements, it increases the bar for the company to meet loftier expectations. If investors feel there is less potential for companies to keep meeting and exceeding expectations, they will sell securities that have outperformed recently to lock in those gains. Swift momentum reversals tend to coincide with market declines.

The negative returns to positive earnings surprises is most likely a function of broader market concerns overwhelming this factor. There have been several instances in the past when response rates were this negative and equity markets rebounded. If market fears worsen, however, there could be less soup for all.

Read more in our Q3 Wall Street Mood Monitor >