By John Mauldin - excerpts by The Advocates

“Any jerk can have short-term earnings.”

– Jack Welch

Profits are the mother’s milk of economic, stock market, and portfolio growth.  Employment and tax revenues are driven by profits, too. Nothing good happens unless there are profits and lots of them. So it is no wonder that we pay attention to the earnings of companies in the stock market quite closely.

It’s quarterly report time for US stocks. If you just casually glance at the earnings news, you might think companies are having a great year. Many are beating expectations and reporting impressive revenues and profits. The markets reward companies for meeting expectations (as we shall see below). But the reality is that the S&P 500 is on track for a sixth straight drop in year-over-year earnings. How do companies keep continuing to beat expectations when earnings are falling?

Their apparent success is explained partly by the fact that earnings reporting is a shell game….

Earnings: The Shell Game

You own stocks for two reasons. You either think the shares will gain value, or they will give you dividend income, or both. Neither will happen unless the company is making money or at least has the plausible hope of making money someday. Earnings reports are important because they tell us whether that’s happening.

The following charts illustrate the “earnings game” being peddled by corporate America through their Wall Street enablers. The graphs shows the average migration of earnings expectations over the course of the year preceding the actual results. The data covers the 17 quarters from the second quarter of 2012 to the second quarter of 2016. Note the large forecasting error (labeled “massive miss” below) between expected results a year in advance and actual results.  Also, notice the better than expected results (“respectable beat”) when compared to expectations at the end of the quarter immediately prior.

This happens all the time, as Lebowitz shows in this chart for the same 17 quarters.

Here’s how Lebowitz explains this chart:

The black line represents quarterly forecasts of earnings growth one year in the future. The green line shows that, six months later, earnings growth has been revised downwards in every instance. Earnings expectations continue to get revised lower as shown by the red line, which represents earnings expectations three months prior to their release. The yellow line shows expectations in the quarter that earnings are due to be released.  As you can see in every instance, earnings expectations are at their highest a year in advance, and lowest in the quarter they are due to be reported. Hardly a coincidence, we suspect.

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