Why This Earnings Season Could Be Especially Dangerous
This week, I’m sitting on the sidelines when it comes to new trade recommendations. It’s rare, but it happens occasionally. And when it does, it’s because we usually find ourselves in an uncertain environment around earnings season.
I’ve written about what I call the “earnings game” several times. In short, the first half is comprised of analyst coming up with estimates for companies — and generally revising them downward. In the second half, the bar is lowered so much that 74% of companies “beat” their forecasts on average.
This is why, as a general rule, I don’t recommend positions that will be open when a company announces earnings. Occasionally, that limits potential trading opportunities. But it’s a game I’m not going to play — because if by chance a company does miss for whatever reason, it creates unnecessary risk.
How The Game Is Playing Out Right Now
Before the end of April, 261 companies in the S&P 500 are expected to announce earnings for the first quarter of the year. That’s an unusually active earnings calendar. Trading ahead of all that news would require accepting a large amount of risk.
By the end of last week, about 50 companies in the S&P reported earnings. The results are significantly better than expected. About 40 of those companies beat expectations for earnings per share, a beat rate of 81%, which is above the five-year average of 74%.
As a group, these companies reported earnings that are 30.3% above the estimates, which is also above the five-year average of 6.9%. If 30.3% is the final percentage for the quarter, it will mark the largest earnings surprise percentage reported by the index since FactSet began tracking this data in 2008.
That may sound good, and it is. But there’s just one problem. A lot of that was driven by the financial sector, and their results somewhat distort the picture. So far, we have seen reports from big banks like JPMorgan Chase, Wells Fargo, Bank of America, and Citigroup. Banks reported year-over-year earnings growth rate of 248%. This comes on revenue growth of just 3%.
Earnings are coming from decreases in reserves for loan losses. As the economy shut down in 2020, banks expected the worst and announced large provisions for potential losses on loans. As the economy reopens and it appears that government stimulus helped companies avoid the worst-case scenario, reserves are being reversed. This added over $12 billion to earnings for JP Morgan Chase, about $9 billion for Citigroup and more than $6 billion for Bank of America.
It’s important to watch announcements over the next two weeks since early reporting was distorted by financial companies. In the next two weeks, it will be important to see if earnings growth is driven by accountants, as it was for the banks, or economic expansion and expectations that growth can continue. For now, it’s not clear what the results will look like. Therefore, to manage risk, I am not recommending a trade this week.
Many traders are very active during earnings season — placing bets and hoping to take advantage of the volatility around earnings to make a quick buck. As you may know, I’m risk averse. I don’t believe in taking unnecessary risks — especially when there will be plenty of good trades for us to make at a later time, thanks to our proven strategies.
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