Earnings Season Preview: Watch for Guidance, Not Results

Next week will see the start of earnings season, the quarterly rush of financial reports from public companies. As we get close, I will make one prediction: I predict that the majority of S&P 500 companies that report will beat analysts' estimates for Earnings per Share (EPS). If you are not familiar with the way earnings work, that may sound like a bold prediction with bullish consequences. However, if you are more familiar with the markets, you will know my prediction actually means very little.

Last quarter, 79% of S&P 500 companies beat those estimates. That was above average, but not by anywhere near as much as you might think. The multiyear average for beats is around 70%, so when I predict that over half will beat the consensus EPS forecast for Q1 2021, I do so with some confidence. In fact, chances are that over three quarters of companies will report an upside “surprise” this quarter too.

Consider the circumstances. The estimates for each quarter are generally based off of a couple of things: the earnings for the same quarter in the previous year, and management guidance for the quarter just finished. This quarter covers last year’s results, which covered the beginning of the pandemic, are extremely hard to interpret, and a lot of CEOs used Covid as an excuse not to issue any guidance throughout last year. Analysts are going into this in the dark and, given their tendency to underestimate even when they have information and data, estimates tend to be conservative even after a series of upward revisions.

Because of those circumstances, neither the year-on-year earnings growth nor the percentage of beats will mean much if anything this earnings season. So, what should investors be looking for?

First is forward guidance, if it returns. There is an increasing school of thought among CEOs that evaluating the performance of a company, and therefore its CEO, based on its ability to meet quarterly targets is ridiculous. They are incentivized to underestimate at all times, hence the big number of beats, which means that guidance has to be taken with a pinch of salt and adjusted for reality. It also means, however, that missing the estimates derived from that fake guidance is severely punished. I mean, if 70% of companies beat and you know the guidance was conservative, a miss must be terrible, right?

Not necessarily. It could be a product of some short-term issues that have no bearing on the company’s prospects or be the result of greater investment or R&D than originally planned, things that will probably improve the outlook. The problem is that misses of the consensus estimate are usually punished, pretty much whatever the reason. So, if you are a CEO who is held responsible for the stock price, why bother to guess and, even more worryingly, why bother to invest?

Still, some brave souls may try to use the Covid-related suspension of guidance as an excuse to stop trying to predict the future, and I wish them luck. Most will probably give in to the pressure and resume the guessing game. Analysts and institutional investors need to have a basis for their estimates that also provide someone to blame if their forecasts are wrong, so they will probably punish anyone who refuses to offer forward guidance.

Even though we know guidance will be distorted, it will still matter to some extent. The market's reaction will depend on the mood at the time. If bullishness continues, low guidance will be seen as understandably circumspect and be discounted, while good guidance will be seen as proof positive that everything in the garden is rosy. If, on the other hand, inflation fears, or an increase in the weekly jobless numbers, or an incautious statement by a Fed board member, or anything else, cause the mood to sour, the opposite will be true.

Earnings season is typically a pivotal time for investors, not just in terms of individual stocks, but also in terms of the overall market direction. This quarter, though, is different. There hasn’t been a pandemic of this magnitude since 1918, so no one knows what to expect at this stage in the recovery. Nor do they know what last year’s numbers meant, nor how circumstances will influence CEOs’ estimates for the coming year.

The most likely outcome, therefore, is that overall reaction to earnings this season is muted but, with an above average number of earnings beats, mildly bullish. Going in at record highs on the major indices, that isn’t a bad thing at all, but I will be looking for something different. If there is a noticeable move away from short-term guidance from CEOs then, while the market may punish those that do that in the short-term, it will set us up for greater stability and further gains in the future.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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