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Investors have stopped rewarding good news

Sam Ro
Managing Editor

Wall Street’s stock market analysts have flagged a somewhat worrisome sign: Investors aren’t cheering earnings surprises by bidding up stock prices.

“Investors did not reward firms that beat expectations in Q2,” Goldman Sachs’ David Kostin observed in a new note to clients. “Since 2006, the median company that surpassed consensus earnings expectations outperformed the S&P 500 by 114 bp the day after reporting. However, in Q2, the median company’s excess return relative to the S&P 500 was just 3 bp, the lowest level on record.”

Bank of America Merrill Lynch’s Savita Subramanian included sales surprises and 5-day stock price reactions in her analysis and she noticed a similar pattern. She warned that this development could be a “portentous sign.”

 

“Companies which beat on top and bottom line have produced no alpha over the next one and five days­ the first time we’ve seen no reward for beats since 2Q 2000 (near the Tech Bubble peak),” Subramanian wrote last week. “Also unnerving, prior to the current quarter, the smallest reward for beats coincided with the Q3 2007 market peak, where beat alpha was a mere 90bp the following day. Beat reactions have been nonexistent across all sectors this quarter, and suggest that expectations and positioning more than reflect the good results.”

In other words, all of the optimism that may be out there is already priced into the stock market. This suggests expectations are high, putting investors at risk of being disappointed.

EPS beats are being met with no reward.

Earnings season has been very strong

Earnings season is wrapping up, with 91% of the S&P 500 (^GSPC) having announced their Q2 financial results. According to FactSet, S&P earnings are estimated to have grown by a healthy 10.2% year-over-year.

“Of these companies, 73% have reported actual EPS above the mean EPS estimate, which is above the 5-year average of 68%,” FactSet’s John Butters observed. “In aggregate, earnings have exceeded expectations by 6.1%, which is also above the 5-year average of 4.1%.”

Overall, the news seems to be good. So, what’s happening here?

Stocks are a discounting mechanism, which means expectations for the future are they key driver of prices. But Butters’ analysis shows that even expectations are still healthy.

“To date, fewer S&P 500 companies have issued negative EPS guidance and more S&P 500 companies have issued positive EPS guidance for Q3 2017 than average,” Butters said. “In aggregate, analysts made smaller cuts than average to third quarter EPS estimates during the month of July.”

It’s usually a risky exercise to draw major long-term conclusions based on a few days worth of price movements.

But with stock prices near all-time highs and valuations well above long-term averages, it’s not unreasonable to think that the bulls are losing some steam here. But does this mean we’re due for a major downturn? We’ll see.

Sam Ro is managing editor at Yahoo Finance.
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