Breakout

Fishy earnings losing the power to move stocks

Jeff Macke
Breakout

Do earnings matter anymore?

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Do earnings matter anymore?

Do earnings matter anymore?
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Stocks may only be flat for the year but there’s a distinct inflation in the number of investors suggesting we’re in the midst of a financial bubble. Despite stocks being relatively cheap based at 15.6x earnings compared to 16.7x and 26.4x at the heights of the 2007 and 2000 bubble tops respectively, many read events such as Facebook’s (FB) $19 billion purchase of messaging company “WhatsApp” and explosive moves in the stocks of companies like Zynga (ZNGA) and FireEye (FEYE) have triggered an explosion of hand-wringing over the rampant speculation that lead to disastrous conclusions to past rallies.

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Speaking to Bloomberg, BNY Mellon Wealth Management’s Jeff Mortimer said the market is being driven by a greedy pursuit of gains and a fear of missing out on future rallies. This greed and fear combination has been a mainstay of markets good and bad for hundreds of years. In the attached video, Yahoo Finance Editor-in-Chief Aaron Task suggests there’s something more at work than human emotions. One of those possible explanations is that earnings aren’t quite as clean a measure of growth they used to be.

“I think we’ve come to learn over the last 20 years that earnings are subject to manipulation,” Task notes. The companies are gaming analyst expectations, typically setting the bar low and issuing the standard “beat by a penny.”

By the rules of economics, corporate earnings should fluctuate. Sometime right around 1981 when Jack Welch took over General Electric (GE), corporations started slightly beating estimates on a regular basis no matter what kind of catastrophe is happening outside the company. Between what Task calls a “black box” driving earnings for which executives were richly rewarded, the system of basing company analysis strictly on growth of earnings per share has lost a significant amount of credibility.

It’s not a matter of outright malfeasance that leads to fishy earnings growth. There’s simply a problem with incentives. Returning to Jack Welch, by Barry Ritholtz’s calculations over the course of Welch’s 18 year tenure at GE, the company grew revenues by 385% and market cap by 4000%. Welch walked away with hundreds of millions while his successor Jeff Immelt was left scrambling to adjust to the loss of GE capital and its piggy bank.

Fear and greed are always part of the equation. If there were a one-size-fits all method for buying stocks someone would have designed it by now. The market is always a combination of fear, greed and price. Those plainly declaring markets a “bubble” are usually trying to justify missing a rally.

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