Earnings season is winding down, and based on the data we’re seeing so far, investors have cause for concern.

What is that, you ask? Because, as I told Income Trader readers earlier this week, I believe the data points to a change in the trend of fundamentals. Specifically, the data I find interesting is the relationship of actual reports to expectations. 

Let me explain…

Expectations Vs. Reality
Over the past five years, on average, 71% of the companies in the S&P 500 beat analysts’ expectations for earnings per share (EPS). About 9% meet expectations, and about 20% miss expectations. 

According to FactSet, 89% of the companies in the S&P 500 had reported earnings through last Friday (Feb. 22). There are a few interesting numbers to consider when looking at the group: 

— 69% beat EPS estimates. This is below the one-year (77%) and five-year average (71%). 
— EPS reports are 3.5% above expectations, on average. This is below the one-year (6.0%) and five-year average (4.8%). 
— 61% beat revenue expectations. This is below the one-year average (72%) and above the five-year average (60%). 
— Sales are 1.1% above expectations. This is below the one-year average (1.4%) and above the five-year average (0.7%). 

All of the numbers are below their one-year average. This is the kind of data we tend to see at turning points. 

Analysts really do try to deliver accurate estimates. But, as a group, their efforts are consistently below actual results. In part, this is because analysts have an incentive to publish estimates that are low rather than high. 

To explain why, I will use a hypothetical. 

#-ad_banner-#Let’s say an analyst consistently posts bullish estimates and the company consistently falls short. Management at that company might not be happy with the analyst. After all, the forecasts make management look like they are failing to deliver. 

Analysts want management teams to be happy with them. At large firms, there are sharp distinctions between research teams and investment bankers. But the researchers understand that investment bankers generate revenue for the firm and there is no need to make their jobs more difficult. 

If estimates are too high and management of the company is not happy, there could be a perception that the company is taking its investment banking business somewhere else. Analysts might do all they can to avoid that. So they will err on the side of caution when developing earnings estimates. 

This shows up in the data when about 70% of companies consistently beat expectations. 

For the fourth quarter of 2018, fewer companies than average are beating expectations. The relationship of how many are beating to the average offers an important insight — earnings are likely to fall in the future. 

To develop estimates, analysts prepare complex models. These models include a large number of variables and assumptions about how the variables will change. For example, an analyst needs to make assumptions about how fast sales will grow, how costs will change, and how interest rates will move. 

In part, many of these assumptions will begin with the expectation that recent trends will continue. 

Let’s say sales have grown by 2% in each of the past four quarters. There are no new products on the horizon. Analysts will most likely assume sales will grow by about 2% next quarter. That’s a simplistic example, but recent trends have to be considered by analysts. 

This means analysts were expecting the fourth quarter of 2018 to be similar to the previous four quarters. But it was not. On average, in the previous four quarters, 77% of the companies in the S&P 500 beat earnings expectations. Just 69% beat in the most recent quarter. 

That indicates recent trends did not continue. Either sales were weaker, or costs were higher. But something was certainly different. 

Comparing the previous four quarters to the previous five years, we see the past four quarters were unusual. On average, in the past five years, 71% of companies beat expectations. In the past four quarters, significantly more than that (77%) beat expectations. 

This was most likely to due to tax reform, which created significant changes to sales, costs and income tax payments throughout the year. Now, it seems like the effect of tax reform is factored into financial models and going forward, the outlook could be disappointing. 

Similar trends are seen in the other numbers above. Companies are beating expectations by less than average and revenue beats are also lower than average. 

Action To Take
This all points to the likelihood that there will be a number of downward revisions from analysts in the next few months. That could be bearish, but for now traders are pushing prices up because of news related to the trade war and other big stories. 

Markets can move higher as fundamentals deteriorate — for a time. However, in the long run, prices move in line with fundamentals. And we have an early warning that fundamentals are weakening in the broad market.

That’s one of the reasons why I’ve been telling investors to start considering more alternative, active strategies — like the options-for-income strategy we use over at my premium newsletter, Income Trader.
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