Richard Bernstein’s 10 Predictions For 2010

With my comments.

1. Stock and bond market returns in the US will again be positive.

With both short and long term rates rising, equities will face new competition and strong headwinds from his #4.

2. The US dollar is likely to meaningfully appreciate once market-driven short-term rates begin to rise.

3. US dollar “carry trades” could get killed as 2010 progresses and the US dollar appreciates.  Once accounting for leverage, hedge fund performance will likely trail long-only equity performance.

4. The Fed will spend the second half of the year trying to catch up to, and flatten, the yield curve. Short-term rates could increase more than investors currently think.  Long-term rates could rise quite a bit in the first part of the year as inflation finally begins to appear, but are likely to fall during the second half of the year when the markets realize the Fed is serious about fighting inflation.  The curve is likely to be much flatter one year from today than it is currently.

5. Corporate profits are likely to explode to the upside during 2010.  Trailing four-quarter S&P; 500 reported earnings growth could exceed 100%.  Investors still seem to be under-estimating the operating and financial leverage that is built into corporate profits.

See the “PROFIT OUTLOOK” section in my post US EQUITIES VALUATION ANALYSIS: DUCK, YOU (HAPPY) SUCKERS!


6. Employment in the US will probably continue to improve. Consumer Discretionary stocks will likely be among the best performing sectors.

7. Treasuries will probably underperform stocks.  That underperformance is unfortunately likely to reinforce both individual and institutional investors’ views that it is wise to be under-diversified.

8. Small cap value, I think, will be the US’s best performing size/style segment.  Small banks outperformance might be the biggest surprise for 2010.

9. Financial regulation will progress, but the bull market will probably aid politicians’ “forgetfulness”.  As a result, new regulation could be relatively meaningless.  In my opinion, serious regulation won’t occur until after the next downturn, which could be worse if no meaningful new regulation is implemented in 2010.

10. I think the Democrats will do better in the 2010 mid-term elections than people currently think they will.  It seems very likely to me that in December 2010, investors will look back on the year and realize that monetary and fiscal policy stimulus still works.

From The Business Insider

 

High-Yield ETFs’ Love-Hate Relationship With Investors

(…) The high-yield boom has packed premiums onto ETFs that may not last. Inflows to high-yield ETFs have been virtually nonstop in the past few years. In order for new units to be created, third parties such as investment banks purchase the underlying bonds in the high-yield market, where transaction costs are high. But such banks will create units to sell to ETF managers only if it’s profitable, or when units are worth more than the cost of the bonds. When the high-yield market was nearly frozen in December 2008, high-yield ETFs traded at premiums of more than 10%, compared with about 1% in today’s healthier market.

What if inflows switch to outflows? As ETFs mature, marginal investor demand will likely decline, especially if the high-yield market falters. Just as investment banks buy bonds to create units, they sell bonds after redeeming units. If the bond market became illiquid again, trading costs would be steep. That could pressure ETF prices down to discounts before investment banks are willing to purchase and redeem units.(…)

Even so, high-yield ETFs offer better liquidity than investors likely can find elsewhere. When high-yield bond markets came to a standstill last year, the ETF market remained active and deep. Investors should just remember such perks don’t come for free.

Full WSJ article

 

17 RULES OF TRADING

Dennis Gartman is a professional trader. There is much wisdom and experience in these rules.

1. NEVER, EVER, EVER ADD TO A  LOSING POSITION: EVER!: Adding to a  losing position will lead to ruin. Count on it. Ask the  Nobel Laureates of Long Term Capital  Management… They’ll tell ya’!

2. TRADE LIKE A MERCENARY SOLDIER:  We must fight on the winning side of the trade, not on the side of the trade we may believe to be
economically correct.

3. MENTAL CAPITAL TRUMPS REAL CAPITAL; Capital comes in two types: mental and real, and holding losing positions costs measurable real capital and immeasurable mental capital.

4. WE ARE NOT IN THE BUSINESS OF BUYING LOW AND SELLING HIGH: We are, instead, in the business of buying high and selling higher, or of selling low and buying lower. Strength begets strength; weakness, weakness.

5. IN BULL MARKETS ONE CAN ONLY BE LONG OR NEUTRAL: The corollary, obviously, is that in bear markets one can only be short or neutral. That may seem self-evident but very few understand it and fewer still embrace it.

6. “MARKETS CAN REMAIN ILLOGICAL FAR LONGER THAN YOU OR I CAN
REMAIN SOLVENT
.” So said Lord Keynes many years ago and he was… and still is right… for illogic does often reign, despite what the academics
would have us believe.

7. BUY MARKETS THAT SHOW THE GREATEST STRENGTH; SELL THOSE THAT SHOW THE GREATEST WEAKNESS: Metaphorically, when bearish we need to throw rocks into the wettest paper sacks for they break most easily. When bullish, we need to sail the strongest winds for they carry the farthest.

8. THINK LIKE A FUNDAMENTALIST; TRADE LIKE A TECHNICIAN: Fundamentals may drive a market and need to be understood, but if the chart is not bullish, why be bullish? Be bullish when the technicals and the fundamentals, as you understand them, run in tandem. Be bearish in the same way.

9. TRADING RUNS IN CYCLES; SOME GOOD, MOST BAD: Trade large and
aggressively when trading well; trade small and ever smaller when trading poorly. In the “Good Times” even one’s errors are profitable; in the inevitable “Bad Times” even the most well researched trade shall go awry. This is the nature of trading; accept it and move on.

10. KEEP YOUR TRADING SYSTEM SIMPLE: Complicated system breed confusion; simplicity breed elegance. The great traders we’ve known have the simplest methods of trading. There’s a connection here.

11. AN UNDERSTANDING OF MASS PSYCHOLOGY IS OFT’TIMES MORE
IMPORTANT THAN AN UNDERSTANDING OF ECONOMICS
: Or more simply put, “When they’re cryin’ you should be buyin’ and when they’re yellin’ you should be sellin’!”

12. BEAR MARKET CORRECTIONS ARE FAR MORE VIOLENT AND FAR SWIFTER THAN ARE BULL MARKET CORRECTIONS: Why this is so remains a mystery to us, but they are; we accept it and we move on.

13. THERE IS NEVER ONE COCKROACH: The lesson of bad news is that more shall follow… usually hard upon and with even more detrimental
effects upon prices.

14. BE PATIENT WITH WINNING TRADES; BE ENORMOUSLY IMPATIENT WITH LOSERS: The older we get the more small losses we take.

15. DO MORE OF THAT WHICH IS WORKING AND LESS OF THAT WHICH IS NOT: This works well in life as well as trading. If there is a “secret” to trading and to life this is it!

16. ALL RULES ARE MEANT TO BE BROKEN: But they are to be broken only rarely and true genius comes with knowing when, where and why.
And the new, winning rule for this year:

17. SOMEONE’S ALWAYS GOT A BIGGER JUNK YARD DOG: Peter Bianco of GLS Capital sent us this winning new “Rule,” and it speaks to the fact that no matter how much “work” we do on a trade, someone knows more and is more prepared than are we… and has more capital

Anybody who is serious about investing should read this classic book on trading:

Reminiscences of a Stock Operator Illustrated

 

JIM ROGERS’ WISDOM

Jim Rogers, investor extraordinaire, gave a short interview to the FT. Some excerpts to remind us of the very basics:

(…) What is the secret of your success?

As I was not smarter than most people, I was willing to work harder than most. I was prepared to examine conventional wisdom. If everyone thinks one way, it is likely to be wrong. If you can figure out that it is wrong, you are likely to make a lot of money.

What is your basic investment strategy?

Buy low and sell high. I try to find something that is very cheap, where a positive change is taking place. Then I do enough homework to make sure I am right. It has got to be cheap so that, if I am wrong, I don’t lose much money. Every time I make a mistake, it is usually because I did not do enough homework.(…)

I’m not buying any stocks at the moment. If anything is undervalued now it is commodities and some currencies.

(…) Invest only in things you know something about. The mistake most people make is that they listen to hot tips, or act on something they read in magazines.

Most people know a lot about something, so they should just stick to what they know and buy an investment in that area. That is how you get rich.

You don’t get rich investing in things you know nothing about.

Full FT interview

 

MARC FABER’S GLOBAL INVESTING OUTLOOK

The Fed’s Misguided Monetary Policy
The monetary policy being pursued by the Federal Reserve, which
is aiming at boosting asset prices, actually leads to more economic and financial volatility. I’d also like to mention that the easy monetary policies of the Fed also lead to colossal debt growth.

image You can print money and you can increase your debt and you can put everything on the balance sheet of the government, but it is unlikely to help the typical household in the United States. It may help Wall Street and it may help some asset markets, but not the standard of living. Otherwise, if money printing would make countries rich Zimbabwe would be the richest country at the present time.

Even under a gold standard, where money and credit is relatively tightly controlled, you can get bubbles in one sector of the economy or another. In this case, everything went up — equity prices, real estate prices, commodity prices — and not just in the U.S., but everywhere in the world. During this period of time, the only thing that went down was the U.S. dollar.

In my opinion, the government in the U.S. will continue to print money, with all the negative consequences that go along with it. And so, I think that looking forward, investors have to be very clear that if the dollar is very weak, there is a chance that equity prices around the world could rally quite substantially.

It’s not so evident that the dollar will totally implode against the euro and other paper currencies because the other central bankers are also money printers. But it is my opinion that it will continue to implode against commodities. Some more than others, but commodities where there are shortages will perform okay. And, in particular, when interest rates are at zero, then obviously gold, silver, platinum and palladium become currency of choice.

I don’t see why someone would hold dollars and not hold some physical gold. There’s no cost associated with holding the gold, compared to dollars that have no return. I think that, gradually more and more people will come to the realization that they have to own some resources, some commodities and some mining companies and obviously some physical precious metal.

How Did Economists Miss the Problem?
There was recently an article by Paul Krugman in the New York Times titled “How Did Economists Get It So Wrong?” Well, first of all, I think the title should have been “How Did I Get It So Wrong?”

I’d also like to point out that not every economist got it so wrong. The economists at the Federal Reserve and the economists at the Treasury and the economists at universities got it so wrong. But private economists have been warning about this excessive debt growth for quite some time, and were very concerned about it.

The real problem of the housing market was not that home prices went down, but rather the excessive leverage of homeowners. Partly encouraged by artificially low interest rates and partly encouraged verbally by the Federal Reserve, homeowners borrowed more and more against their homes. That’s why I find the Fed essentially mistaken in its belief that the problems were not foreseeable.

Total New Borrowings by Households and Non-Financial Business % PGDP
image

PGDP = Implicit Price Deflator for GDP
Source: Bridgewater Associates, Goldman Sachs

The chart above shows total new borrowings by households and non-financial businesses. Credit growth accelerated to a peak annual rate of 18 percent at the end of 2006. It slowed down following the rate cut in September 2007, then accelerated once again a little bit. Then in 2008, it totally collapsed. And, of course, for an economy that is driven by credit, such as the U.S., a total credit growth collapse is a disaster.

The private sector is now de-leveraging. Households and businesses are behaving rationally – they are saving more, they are paying down their debts. That’s a rational action to take in a recession such as we have. At the same time, the government has come in and built up – the U.S. Treasury as a percent of the economy has expanded very rapidly. The fiscal benefits this year will probably be around $2 trillion.

The problem with all this is, in my opinion, is that the government’s role can’t really come down significantly because the moment you reduced your fiscal deficit, you would again have a negative impact on the economy. So I think that as far as the eye can see, we will have artificially low interest rates, near zero percent, because unemployment in the U.S. is not going to go away overnight. And at the same time, the deficit will stay very high and that will lead, in my opinion, sometime down the road to more inflation, which will then necessitate more money-printing, in order to keep short-term rates artificially low.

Bright Future for Resources
I think that gold is a desirable asset, but for my taste there was a little bit too much euphoria just recently, when gold went over $1,000. And so what we could get is kind of a correction in gold, and then a little bit of a rebound in dollars.

The exploration companies were decimated in 2008 and they have recovered, but in my opinion, they still offer very good value. What has to be clearly understood is that exploration companies don’t really have a cash flow, and they have to discover something to make it work. Many exploration companies will not survive and others will be taken over by the majors. There will be a lot of volatility in the sector, but it’s an exciting sector.

I feel that the demand for resources overall is actually well-supported, and there’s another factor that’s important to understand. The bull market in commodities that began in essentially 2001 and lasted to 2008 was, in my opinion, too short to really trigger a supply response. Once the market collapsed in 2008, a lot of projects were canceled and a lot of exploration companies didn’t get the money they needed to carry on with their exploration work.

In the case of oil, the peak for new discoveries came in the 1950s and 1960s. Since then new oil reserves continue to be found but in smaller and smaller quantities, and also at higher and higher costs in areas that are inhospitable or very deep at sea.

When I look at the oil demand pattern of China and India and then I look at the supply pattern, I think that oil prices will have a rising trend. And here, leaving out the money-printing function of Mr. Bernanke, the more money you print, the more oil and other commodities go up.

Growing Clout of Emerging Markets
I have to say that, probably in our whole lifetime, we will never again have this kind of synchronized boom that we experienced in the period 2005 to 2007. It is most unusual economically that the whole world was in boom condition, and in the future, I would rather expect that some countries will do well and others will do less well.

For 200 years it was the
rich countries of the West that essentially became richer and richer, and for the first 150 of those 200 years, what are now called “emerging economies” were colonies and thereafter they had regimes that were not particularly desirable. But now these countries have been unleashed. In the past, the rich countries of the West financed economic development in poor, emerging countries. But now the foreign exchange reserves are in emerging economies.

I mention this because sometimes people still think that emerging economies are poor, or that the emerging economies depend very much on the West. That is no longer the case. They are a very, very powerful economic bloc, and they will become a very, very powerful political bloc as well, and a military bloc. And that is something that will create a lot of tension in the world

The strong economic development in Asia has obviously slowed down because we have a recession and exports collapsed. But Asia is not going to stop buying commodities. The Chinese have very little natural gas, they have little crude oil, they have very little iron/ore and copper. They may buy less in any given year, but there is not going to be a situation where they won’t buy anything at all.

Chinese steel production went from 10 percent of the world’s total in 1990 to more than 40 percent now. For aluminum, production in China went from 10 percent of the world’s total in the year 2000 to now more than 30 percent. That isn’t going to go away because a lot of this production is actually not for export, but rather for domestic consumption.

The per-capita consumption of oil and other resources in China and India is still extremely low compared to say more advanced economies, such as Japan, South Korea and, of course, the energy-wasting United States. That is shown on the chart below. I would argue that actually oil demand in China will have trend-line growth of between 6 percent and 9 percent annually for the next 10 to 20 years, and in India, trend line growth, in my opinion, will be between 5 percent and 7 percent annually.

image

Rise of the Asian Consumer
In China and in the whole of Asia and the emerging world, we still have a lot of poverty and we have a lot of people who can’t afford to live a very free life. In other words, they can’t afford to travel and they can’t afford to make many choices in their lives.

But at the same time, in both India and China, you have the emergence of a hardworking urban class — these are people who work for companies in clerical positions and also in management positions and they do relatively well. So if you have 1.3 billion people, all you need is essentially 200 million people that live a reasonable lifestyle and you have a huge market.

Over time, starting from a low level, these countries move up the scale in terms of standard of living. Their GDP per capita improves and the middle class expands. Now is everything perfect? No. And is the stimulus package in China working? Probably not very well. It leads to a lot of speculation and further reallocation of resources, bubbles in property and so on.

But I take the view that, if you look at the next 10 to 20 years, I don’t see how the lifestyle of the average person in Western Europe and in the U.S. will improve meaningfully. I just don’t see it. On the other hand, if I look at a country like Vietnam, it has GDP per capita annually of $800, which may go to $3,000 over the next 15 to 20 years. The same idea holds for China and India.

You will have in India a middle class of maybe 200 million or 300 million people. They will not all buy Mercedes Benz cars, but they will buy a Nano for $2,500. And that will require resources and it will eventually also be an incentive for people to work very hard.

When a family moves from the bicycle to the motorcycle, it’s an improvement in their standard of living. But then when you move to the car and you drive your children in a car to school, it’s a huge increase in your standard of living, and also in your social class. In the Western world, I think that they will be at war and they will have civil unrest and their standard of living will not be as good.

From US Global Investors

 

How to invest like Buffett

1. Buy businesses with a sustainable competitive advantage

2. Don’t buy businesses you don’t understand

3. Look for consistently high return on equity

4. Beware of debt

5. Avoid commodity businesses

6. Look for increasing profit margins

7. Think like an owner

8. Buy at a discount

9. Focus on the long-term

Read the full Globe and Mail article

Visit the News-To-Use Amazon book store section devoted to Warren Buffett

 

JEREMY GRANTHAM: The Last Hurrah and Markets Being Silly Again

I do not agree that the S&P; 500 Index is as overvalued as Grantham says (see EQUITY VALUATION ANALYSIS, AUGUST 2009). The fact that he finds “high quality” stocks cheap supports my views. In fact, his top-down analysis is bearish while his bottom-up work finds “a sufficient group of equities at or very close to fair value”. At the end of his comment, he goes even further saying that “quality stocks (high, stable return and low debt) simply look cheap”.

Economic and Financial Fundamentals and the Stock
Market Outlook

The good news is that we have not fallen off into another Great Depression. With the degree of stimulus there seemed little chance of that, and we have consistently expected a global economic recovery by late this year or early next year. The operating ratio for industrial production reached its lowest level in decades. It should bounce back and, if it moves up from 68 to 80 over three to five years, will provide a good kicker to that part of the economy. Inventories, I believe, will also recover. In short, the normal tendency of an economy to recover is nearly irresistible and needs coordinated incompetence to offset it – like the 1930 Smoot-Hawley Tariff Act, which helped to precipitate a global trade war. But this does not mean that everything is fine longer term. It still seems a safe bet that seven lean years await us.

Corporate ex-financials profit margins remain above average and, if I am right about the coming seven lean years, we will soon enough look back nostalgically at such high profits. Price/earnings ratios, adjusted for even normal margins, are also significantly above fair value after the rally. Fair value on the S&P; is now about 860 (fair value has declined steadily as the accounting smoke clears from the wreckage and there are still, perhaps, some smoldering embers). This places today’s market (October 19) at almost 25% overpriced, and on a seven-year horizon would move our normal forecast of 5.7% real down by more than 3% a year. Doesn’t it seem odd that we would be measurably overpriced once again, given that we face a seven-year future that almost everyone agrees will be tougher than normal? Major imbalances are unlikely to be quick or easy to work through. (…)

To repeat my earlier forecast, I expect developed markets to grow moderately less fast – about 2.25% – for the next chunk of time, and to look pretty anemic compared to emerging countries growing at twice that rate. We are nervous about the possibility of a major shock to Chinese growth. (My personal view of a major China stumble in the next three years or so is that it is maybe only a one in three chance, but is still the most likely important unpleasant surprise of the fundamental economic variety.) Notwithstanding this concern, I believe we are well on the way to my “emerging emerging bubble” described 18 months ago (1Q 2008 Quarterly Letter). I would recommend to institutional investors, including my colleagues, to give emerging equities the benefit of value doubts when you can. (…)

We believed from the start that this market rally and any outperformance of risk would have very little to do with any dividend discount model concept of value, so it is pointless to “ooh and ah” too much at how far and how fast it has traveled. The lessons, if any, are that low rates and generous liquidity are, if anything, a little more powerful than we thought, which is a high hurdle because we have respected their power for years. (…)The Fed’s weapons of low rates, plenty of money, and the promise of future help if necessary seem stronger than value over a few quarters. And the forces of herding and momentum are also helping to push prices up, with the market apparently quite unrepentant of recent crimes and willing to be silly once again. We said in July that we would sit and wait for the market to be silly again. This has been a very quick response although, as real silliness goes, I suppose it is not really trying yet. (…)

Price, however, does matter eventually, and what will stop this market (my blind guess is in the first few months of next year) is a combination of two factors. First, the disappointing economic and financial data that will begin
to show the intractably long-term nature of some of our problems, particularly pressure on profit margins as the quick fix of short-term labor cuts fades away. Second, the slow gravitational pull of value as U.S. stocks reach +30-35% overpricing in the face of an extended difficult environment.(…)

So, back to timing. It is hard for me to see what will stop the charge to risk-taking this year. With the near universality of the feeling of being left behind in reinvesting, it is nerve-wracking for us prudent investors to contemplate
the odds of the market rushing past my earlier prediction of 1100. It can certainly happen. Conversely, I have some modest hopes for a collective
sensible resistance to the current Fed plot to have us all borrow and speculate again. I would still guess (a well informed guess, I hope) that before next year is out, the market will drop painfully from current levels. “Painfully” is arbitrarily deemed by me to start at -15%. My guess, though, is that the U.S. market will drop below fair value, which is a 22% decline (from the S&P; 500 level of 1098 on October 19).(…)

Forecast Summary
Bonds, except emerging, have very low seven-year return forecasts: on our numbers, they are below 1.25% real. The forecast for the S&P; 500 is well below 3%, but the high quality subset is still handsome. We score international
developed stocks as close to fair value, and emerging equities as expensive, although just within range of normal if I am allowed to give them a seven-year bonus of 2% a year (15% in total).

Portfolio Recommendations
Having reinvested back in March to be almost neutral in equities, we have recently taken just a few chips off the table and recommend that anyone who was neutral weighted in equities or even over weighted (lucky you!) do the same. For us, the neutral 65% equity position that we reached has been slightly pulled back to 62%, leaving plenty of room to pull back further if the market runs above 1100, say, to 1200 later this year. This reduction is slight for two other reasons. First, we can find a sufficient group of equities at or very close to fair value. U.S. high quality, foreign developed (EAFE), and some emerging (with the benefit of the doubt) are collectively a reasonable buy. [Let me take a moment to make it clear that this is my personal view on emerging, since my suitably stern colleagues don’t believe in giving the benefit of the doubt, and feel that the overpricing of emerging should
determine everything. This is a pretty mild disagreement, and I recognize that I may be getting carried away by my confidence in an emerging bubble.] The second reason for the smallness of our pullback is that typically we do not micromanage the portfolio dispositions, but try to allow for extremes to occur and then make a very significant move. Although the U.S. market is still in a
routine overpricing range, we are making an exception this time since we had a strong prior assumption in April that a healthy last hurrah would overrun and eventually slam into the longer-term disappointments of the seven lean years variety. And it still seems likely to work out that way. So we are breaking our rules and teasing out a few percentage points more of safety margin as the
market runs. The 1Q 2009 Quarterly Letter, by the way, said “in a rally to 1000 or so, the normal commercial bullish bias of the market will of course reassert itself, and ev
eryone and his dog will be claiming it as the next major multi-year bull market.” Well, now it’s happened precisely that way, and you should not believe them! As we have demonstrated to our clients in earlier cycles, earnings estimates in particular merely follow the market up (not the other way around, as one would hope). So it is a law of nature that strong estimates will abound after a major market rally. The earnings and economic growth estimates in such cases are usually throwaways.

But the economic data next year will indeed look strong. The irony may well be that just as nine months of weak economic data this year has been accompanied by a very strong market, so the strong economic data next year is
likely to be accompanied by a weak stock market.

Yet Another Plug for U.S. Quality Stocks
Our main argument is quantitative. Quality stocks (high, stable return and low debt) simply look cheap and have gotten painfully cheaper as the Fed beats investors into buying junk and other risky assets, a hair-of-the-dog strategy if ever there was one. In our seven-year forecast the quality segment has a full seven-percentage-point lead over the whole S&P; 500, or 9% over the balance ex-quality. This is now at genuine outlier levels.

In addition, there are qualitative arguments. We like owning high-quality blue chips if we are indeed going into a more difficult seven years than any we have faced since the 1970s. The problems of reducing debt and the potential share dilution that can go with it as it did in Japan for a decade, particularly play to the strength of the largely debt-free high-quality companies. And for
nervous investors there is yet another reason for favoring quality stocks: their more than 50% foreign earnings component, which is higher than the balance of the S&P;  500 with its heavy financial component. In the long run, quality stocks have proven to be the one free lunch: you simply have not had to pay for the privilege of owning the great safe companies, as plain logic and established theory would both suggest.

Full comment

 

ESTIMATE REVISIONS AND “THE EARNINGS SEASON RACKET”

The trend in earnings revisions is more important than beat rates. Corporate officers know the game: under-promise to over-deliver! But in the end, the trend in annual earnings revisions is more important than quarterly profit performances.

Doug Kass penned a column for TheStreet.com on Wednesday titled "The Earnings Season Racket."  Kass argues that the earnings "beat" rate is so high this quarter because of lowered estimates, and that "companies almost always beat earnings forecasts even during rough economic periods."  Below is a portion of his column:

While it has been widely advertised by chest-thumping bulls in the media that at least two-thirds of the companies that have reported third-quarter earnings have beaten forecasts, there was less than meets the eye to third-quarter profits as in many cases the "beats" were on lowered estimates.

What is often being ignored is how orchestrated earnings season has become, not only that the beats are from lowered and depressed guidance but that, in many cases, there have been high-profile forward-quarter guide downs.

The reality is that companies almost always beat consensus earnings forecasts, even during rough economic periods. Investor relations departments and Wall Street analysts are very good at getting numbers down to the right level before reports are released. As a result, the actual results vis-a-vis expectations or consensus do not vary materially from historical experiences, in good times and even in bad times.

The argument that earnings are beating estimates simply because estimates had gotten so low has been one that bears have been using this entire bull market.  In reality, however, estimates have increased significantly in recent months.  Back in October 2008, net earnings revisions (% of increases to decreases in revisions) had tanked to multi-year lows.  But it also bottomed that month and then traded sideways until February 2009.  Just prior to the market lows in March, however, the net earnings revisions ratio began to tick higher.  Earlier this summer, the earnings revisions ratio actually moved into positive territory, which meant anaysts were raising estimates for companies more than they were lowering them.  Leading up to this earnings season, the percentage of companies raising estimates hit a two-year high.  Upside estimates have been outpacing downside estimates for a few months now, and companies have still been able to beat estimates at a high rate, which we believe is a major reason for the rise in the overall market.

Estrevisions

Kass’ argument that companies almost always beat consensus forecasts even during tough times also needs some explaining.  Over the last decade, 62% of the tens of thousands of earnings releases were better than analyst expectations.  But the beat rate has had pretty big swings from a quarter to quarter basis that has ranged from 50% to nearly 75%.  While the majority of stocks are going to beat in any given quarter, some quarters are significantly better than others.

Below is a chart showing the quarterly earnings "beat" rate going back to 1998.  As shown, the beat rate was strong during the last couple quarters of 1999, and it peaked in Q1 2000 just as the market peaked. 

Epsbeatrate1

From that point until Q3 ’01, the "beat" rate remained below 60% and trended lower.  From Q4 ’01 (which would have been the numbers released in January/February 2002) to Q1 ’04, the beat rate progressively increased each quarter. This coincided with a big increase in the stock market as well.  The last peak that we saw in the quarterly "beat" rate came in Q3 ’06 when 73% of companies beat estimates.  The number remained above 60% through Q3 ’07, but it had started its drift lower.  This downtrend continued all the way until Q4 ’08 (numbers released in January/February ’09) when the "beat" rate hit a low of 55%.

The earnings season in April and May of this year was the first increase in "beat" rates since Q1 ’07.  In that earnings season, the "beat" rate came in at 62%, which was surprisingly positive at the time, and one reason why the market did very well during over the spring and summer.  The "beat" rate got even better last earnings season (68%), and we’re on pace to have the best "beat" rate since at least ’98 this quarter.

To brush off the earnings "beat" rate because earnings "almost always beat estimates" is not a good idea.  We believe it’s important to follow the trend in quarterly "beat" rates, as a trend higher is indicative of a strong market, while a trend lower is a negative sign.  Surprisingly better than expected earnings reports have been a big part of the current bull market.

If Kass wants a bearish argument, he could actually make the case that the high "beat" rate this quarter will most likely be the peak in the cycle since it is so high.  It’s going to be tough for the next earnings season to have a stronger "beat" rate than this quarter, which could mean the start of a downtrend.  But nowhere in Kass’ column does he mention this.

In conclusion, the data shows that companies have been beating raised estimates and not lowered ones during this bull market, and the direction of quarterly "beat" rates is a trend that investors should definitely follow.

Bespoke Investment

Look at how earnings started to get revised upward last spring. That is fuel to stocks in a low interest rates environment. Now it will be interesting (read crucial) to watch how the 2010 estimates will change in coming weeks.