Earnings Estimates’ Effect on Stock Prices
Thursday, October 20, 2016

One of the most-discussed stock screens on our discussion boards is Estimate Revisions: Up 5%. The screen seeks out companies with a one-month increase in the consensus earnings estimate for the current year of 5% or more. A post about the screen currently has 86 responses.

Earnings estimates are forecasts made by analysts about how much a company will earn over a given quarter or year. The consensus estimate is simply the average of all the analysts’ forecasts made for a given quarter or year. Changes in consensus earnings estimates are a driver of stock prices. Positive estimate revisions lead to higher stock prices and negative estimate revisions lead to lower stock prices.

Beyond the direction of the change is the dispersion of the individual forecasts. Analysts frequently engage in herd mentality behavior by keeping their forecasts close to the consensus. A comparatively few brave souls do venture out to the edge with bold projections, but they are not the norm. It can be worthwhile to look at the outlier forecasts and how actual earnings compare to them. A study in this month’s Financial Analysts Journal says that the price reaction is larger for companies whose beats (actual earnings above the consensus estimate) exceed the most positive forecast or whose misses (actual earnings below the consensus estimate) are below the most pessimistic forecast.

The price reaction following an earnings surprise is referred to as the post earnings announcement drift, or simply “PEAD.” It is typically positive for a beat and negative for a miss. Though there is often an immediate reaction the day of the announcement or the day after, for companies reporting after the close of trading a tail tends to follow. This ongoing reaction reflects slowness on the part of investors (institutional and individual) in absorbing the information and reassessing their outlook for the stock.

The PEAD can continue for an extended period of time in either direction. This is because of what is known as the cockroach effect: when you see one, there are usually more. Positive earnings surprises tend to be followed by more positive surprises; negative earnings surprises tend to be followed by more negative surprises. The surprises lead to repeated revisions to earnings. Anchoring also plays a role. Analysts and investors set their expectations on one set of data. When new information is released, there is typically a delay in the adjustment of these expectations as business conditions continue to be better or worse than anticipated.

Strategies based on earnings estimate revisions can have high turnover if a quantitative approach is strictly followed due to the seasonal nature of revisions. Between now and approximately mid-November, the number of earnings estimate revisions will jump significantly due to earnings announcements. As we move away from third-quarter earnings season, the number of estimate revisions will fall considerably. The seasonal cycle causes more stocks to pass earnings estimate revisions screens during the early to mid part of a calendar quarter and fewer near the end and very beginning of a calendar quarter. Thus, investors can significantly reduce transaction costs by holding onto stocks bought based on revisions to earnings estimates when there is no or very little revision due to the calendar.

Keep in mind that, as with other anomalies, strategies based on earnings estimates don’t work all the time. We saw this earlier in the year with energy stocks. Though analysts were cutting their forecasts, the rebound in oil prices prompted traders and investors to shift money back into shares of energy companies. Such situations can occur when pessimism swings too far toward worst-case scenarios and evidence emerges that conditions are not as bad as feared. The damaging effects of the storm remain, leading analysts to continuing cutting their forecasts. However, the damage is less than what investors feared, which is helping to boost stock prices. Even when factoring in such situations, long-term returns continue to show that being optimistic about positive earnings estimate revisions and pessimistic about negative estimate revisions is a profitable strategy.

Social Security Increases for 2017 Announced

Earlier this week, the Social Security Administration announced a 0.3% cost of living increase (COLA) in monthly benefits. Medicare Part B premiums for 2017 have not been announced, though an increase is expected.

The limit on the amount of wages subject to Social Security taxes will increase to $127,200 from $118,500. The 7.3% hike is the largest in more than five years, according to my calculations. The Social Security Administration says the adjustment is based on the on the increase in average wages.

The retirement earnings test exempt amounts will rise by 7.6%, to $16,920 per year, for those under full retirement age (FRA). For those at or above FRA, $44,880 per year in earnings will be exempt.

The Social Security Administration has a fact sheet detailing the changes.

More on AAII.com

  • Earnings Estimates – I discussed in greater detail what earnings estimates are and why they matter in this May 2015 AAII Journal article.
  • Why Value Beats Growth: A Brief Explanation – When the dispersion among analysts’ forecasts is too large, stocks tend to outperform, as Peter Berezin of BCA Research explains.

Highlights from this month's AAII Journal

AAII Model Portfolio Update

No changes were made to the Model Fund Portfolio during the quarterly review. The Model Shadow Stock Portfolio will be reviewed in mid-December. As such no changes were made this month. The Model Portfolios Update email alerts AAII members when changes are announced. It is free with your AAII membership.

The AAII Model Shadow Stock Portfolio, which is a real-money portfolio of micro-cap value stocks, rose 2.1% in September. This was better than the DFA U.S. Micro Cap Fund (DFSCX), which gained 0.7% in September. Year to date, the AAII Model Shadow Stock Portfolio is up 14.2%, compared to the S&P 500 as represented by the Vanguard S&P 500 index fund (VFINX), which is up 7.7%. The DFA U.S. Micro Cap Fund (DFSCX) is up 10.6% for the nine months ended September 30. Since its inception in 1993, the AAII Model Shadow Stock Portfolio has a compound annual average return of 15.6% versus the Vanguard S&P 500 Index fund, which as gained 9.0% a year, on average, over the same period.

The AAII Model Fund Portfolio climbed 1.2% in September, compared to a 0.02% total return for the SPDR S&P 500 ETF (SPY). The Model Fund Portfolio has gained 10.1% year to date, while the SPDR S&P 500 ETF is up 7.7%. Since its inception in June of 2003, the Model Fund Portfolio has a compounded annual average return of 8.5%, while the SPDR ETF has an 8.3% average annual return over the same period.

The Week Ahead

Third-quarter earnings season will hit full stride, with 178 members of the S&P 500 on the docket. Included in this group are 12 Dow Jones industrial components: Visa (V) on Monday; 3M Co. (MMM), Apple (AAPL), Caterpillar (CAT), DuPont De Nemours (DD), Merck & Co., (MRK), Procter & Gamble Co. (PG) and United Technologies Corp. (UTX) on Tuesday; Boeing Co. (BA) and The Coca-Cola Co. (KO) on Wednesday; and Chevron Corp. (CVX) and Exxon Mobil Corp. (XOM) on Friday.

The week’s first economic report of note will be the October purchasing managers manufacturing index (PMI), which will be released on Monday. Tuesday will feature the August S&P/Case-Shiller home price index (HPI) and the Conference Board’s October consumer confidence survey. September international trade and September new home sales will be released on Wednesday. Thursday will feature September durable goods orders and the September pending home sales index. The first estimate of third-quarter GDP, and the University of Michigan’s final October consumer sentiment survey will be released on Friday.

Four Federal Reserve officials will make public appearances on Monday: New York president William Dudley, St. Louis president James Bullard, Chicago president Charles Evans and governor Jerome Powell.

The Treasury Department will auction $26 billion of two-year notes on Tuesday, $15 billion of two-year floating rate notes and $34 billion of five-year notes on Wednesday, and $28 billion of seven-year notes on Thursday.

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AAII Sentiment Survey

Optimism among individual investors about the short-term direction of stock prices fell to an unusually low level, one not seen since last June. The latest AAII Sentiment Survey also shows an increase in pessimism and a decrease in the percentage of investors describing their outlook as neutral.

Bullish sentiment, expectations that stock prices will rise over the next six months, declined 1.7 percentage points to 23.7%. Optimism was last lower on June 22, 2016 (22.0%). This week’s drop puts optimism below its historical average of 38.5% for the 50th consecutive week and the 83rd out of the past 85 weeks.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, fell 2.4 percentage points to 38.4%. This is a four-week low. Nonetheless, neutral sentiment is above its historical average of 31.0% for the 38th consecutive week.

Bearish sentiment, expectations that stock prices will fall over the next six months, rose 4.1 percentage points to 37.8%. The increase puts pessimism at a four-week high and above its historical average of 30.5% for the sixth time in eight weeks.

This week’s bullish sentiment reading ranks as the 104th lowest reading out of the more than 1,500 weekly results recorded during the 29-year history of our weekly survey.

Since reaching 35.6% in mid-August, optimism has declined during eight out of nine weeks. Large-cap stock prices are only down modestly since then, and small-cap stocks have been essentially flat over this period. Both have generally trended downward this month. The lack of new market highs may be playing a role in dampening optimism.

Also causing concern for some investors is the possibility of the stock market experiencing a larger drop, valuations, the November elections, global economic uncertainty and the pace of corporate earnings growth. Giving other individual investors reason for optimism are the perceived lack of investment alternatives, corporate earnings, low/stable energy prices and sustained, albeit slow, economic growth.

This week’s special question asked AAII members about their perception of the current state of the housing market. The two largest groups of respondents were nearly evenly split, and opinions overall were mixed. Nearly 27% of described the housing market as either being overvalued, weak or otherwise at risk of weakening. About 25% described the housing market as being good and/or continuing to do well until interest rates increase. Slightly more than 11% said housing is growing slowly, while 7% think housing is in a bubble and 6% believe the housing market is steady.

Here is a sampling of the responses:

  • “Decent, but it’s not clear about the overall demand. Some markets are hot, while some are not.”
  • “Prices are rising a bit here and there, but there is no bubble building.”
  • “Market is picking up slightly and should continue to expand at a modest pace.”
  • “A little ahead of itself. The anticipated, gradual rise in interest rates should make real estate a relative underperformer in the next couple of years.”
  • “Where I live housing prices have increased too fast and do not seem to be sustainable.”
  • “Ready for a correction. Only low mortgage rates are propping up the market.”

This week’s Sentiment Survey results:

Bullish: 23.7%, down 1.7 points
Neutral: 38.4%, down 2.4 points
Bearish: 37.8%, up 4.1 points

Historical averages:

Bullish: 38.5%
Neutral: 31.0%
Bearish: 30.5%
Take the Sentiment Survey.

Local Chapter Meetings
AAII Local Chapter Meetings offer you a variety of presentations from expert speakers who will give you their view on the world of investing. A bonus of attending a Chapter Meeting near you is the opportunity to meet other AAII members who share your interest and enthusiasm for investing. You can even share the Chapter experience with your family and friends by inviting them to attend Chapter Meetings with you!