Jonathan Davis: In this market, the innocents suffer along with the guilty

'What is dragging the market down are the few big companies missing expectations by a wide margin'

One of the main reasons stock markets have again been falling is the evidence that corporate earnings have been coming in well below expectations. Like all statements about the market as a whole, even such a simple one as this turns out not to be quite as straightforward to interpret as it first appears. For one thing, it begs the question whether it is poor earnings or excessive expectations that are most to blame.

Money net

One of the main reasons stock markets have again been falling is the evidence that corporate earnings have been coming in well below expectations. Like all statements about the market as a whole, even such a simple one as this turns out not to be quite as straightforward to interpret as it first appears. For one thing, it begs the question whether it is poor earnings or excessive expectations that are most to blame.

First, there is a lot of variation from one stock to another. In the Footsie 100 index, for example, there are a sizeable minority of companies whose earnings estimates are being revised upwards rather than downwards.

Overall, the number of disappointments outweigh the number of positive surprises, but the picture itself is more mixed than the headline figures suggest. Despite all the nonsense that pours out of many corporate headquarters about loss of "earnings visibility", a fair number of high-quality companies continue to churn out perfectly respectable high single-figure or double-digit earnings growth. Charles Dunstone, of Carphone Warehouse pleased the market this week, but he was in a minority.

Secondly, what is dragging the market down particularly hard are a few companies that are missing market expectations by a wide margin. Companies suffering the worst disappointments are often, unsurprisingly, the slowest and least effective at communicating their concerns to the marketplace.

By definition, it is much easier to manage investors' expectations if you are running a large, branded business with powerful franchises and lots of pricing power, than if you are a second-rate industrial company whose customers are deserting in droves and where the bank manager is sitting in reception demanding to be seen.

Thirdly, the whole game of managing earnings expectations is changing. You may recall how even before Enron and the other accounting scandals started breaking that the Securities and Exchange Commission introduced new so-called "fair disclosure" rules in the US market. These were designed to replace the insidious practice of companies giving selective private briefings to analysts about future earnings with the principle of simultaneous public disclosure of any earnings-sensitive information.

This has led to the practice of companies getting into the "market guidance" game, that is, making regular public statements about their future earnings prospects and how their internal figures stand in relation to the consensus estimates of the market. This has not stopped investors and analysts from continuing to hold inflated expectations about many companies' prospects.

Now that earnings figures themselves have coming increasingly under the spotlight, and companies are having to justify their figures with more rigorous accounting, it is obvious that if making stock selection on the basis of forecast earnings is your game, the rules and the quality of the raw material have now turned against you. This may be a temporary effect, and once the various accounting and regulatory changes have been absorbed, it will be easier to place more faith in future earnings projections. But at present it is a hazardous game.

The profession of sell-side analyst (if it can be called a profession) has gone seriously ex-growth, as their steady exodus from banks and broking firms bears witness. Many analysts at broking firms became captives of their firm's investment banking or corporate broking arms during the great bull market, and abandoned any pretence of independent analysis in favour of becoming accomplices to stock promotion, as the recent disclosures about the goings-on at some of the biggest investment banks makes clear.

It is little surprise that earnings figures are causing so much disruption. Investors are already jittery, and their lack of confidence in earnings projections is spreading like a contagion. The market is punishing most heavily those firms that produce the biggest earnings disappointments, but companies with the best earnings momentum continue to outperform the rest of the market.

The most encouraging news is that, as often happens, the contagion is spreading not just to those stocks that deserve the re-rating but others that arguably deserve more favourable treatment. Research by CSFB shows the 20 per cent of European stocks with the best earnings momentum have outper- formed the market by 10 per cent since the start of the year, and the 20 per cent with the worst experience have underperformed by 15 per cent. But, in absolute terms, many of the virtuous are still suffering along with the rest, as always happens in bear markets.

It is reaching the point, as was noted here a few weeks ago, that it is at last producing genuinely interesting buying opportunities, at least for those with reasonably medium-term horizons. The market may yet break through its late summer lows and extend the bear market by one further leg – it is hard to say market sentiment is positive at present – but the number of large, well-capitalised stocks that have strong, consistent earnings records as well as, in many cases, healthy dividend yields is increasing by the day. Some are worth adding selectively to your stock watch list.

Remember that bear markets, when they do end, tend to do so suddenly, and when they do, it is because investors have forgotten about the need to look at fundamental value and are instead so bewitched by the day-to-day price movements that they have lost sight of the more important issues, just as they do the other way round at the top of a bull market.

davisbiz@aol.com

Independent Partners; request a free guide on NISAs from Hargreaves Lansdown

Voices
There will be a chance to bid for a rare example of the SAS Diary, collated by a former member of the regiment in the aftermath of World War II but only published – in a limited run of just 5,000 – in 2011
charity appealTime is running out to secure your favourite lot as our auction closes at 2pm tomorrow
Arts and Entertainment
Mark Wright and Bianca Miller in the final of The Apprentice
tvMark Wright and Bianca Miller fight for Lord Sugar's investment
Arts and Entertainment
X Factor winner Ben Haenow has scored his first Christmas number one
music
Arts and Entertainment
James May, Jeremy Clarkson and Richard Hammond in the Top Gear Patagonia Special
tv
PROMOTED VIDEO
News
File: James Woods attends the 52nd New York Film Festival at Walter Reade Theater on September 27, 2014
peopleActor was tweeting in wake of NYPD police shooting
News
Claudia Winkleman and co-host Tess Daly at the Strictly Come Dancing final
people
News
i100
Extras
indybest
News
peopleLiam Williams posted photo of himself dressed as Wilfried Bony
Sport
Martin Skrtel heads in the dramatic equaliser
SPORTLiverpool vs Arsenal match report: Bandaged Martin Skrtel heads home in the 97th-minute
Arts and Entertainment
The Apprentice finalists Mark Wright and Bianca Miller
tvBut who should win The Apprentice?
News
The monkey made several attempts to revive his friend before he regained consciousness
video
Extras
indybest
News
Elton John and David Furnish will marry on 21 December 2014
peopleSinger posts pictures of nuptials throughout the day
Life and Style
A still from the 1939 film version of Margaret Mitchell's 'Gone with the Wind'
life
Finacial products from our partners
Property search
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

ES Rentals

    iJobs Job Widget
    iJobs Money & Business

    Carlton Senior Appointments: Private Banking Manager - Intl Bank - Los Angeles

    $200 - $350 per annum: Carlton Senior Appointments: Managing Producer – Office...

    Carlton Senior Appointments: San Fran - Investment Advisor – Ind Advisory Firm

    $125 - $225 per annum: Carlton Senior Appointments: San Fran - Investment Advi...

    Sheridan Maine: Commercial Finance Manager

    Up to £70,000 per annum + benefits: Sheridan Maine: Are you a qualified accoun...

    Sheridan Maine: Regulatory Reporting Accountant

    Up to £65,000 per annum + benefits: Sheridan Maine: Are you a qualified accoun...

    Day In a Page

    The week Hollywood got scared and had to grow up a bit

    The week Hollywood got scared and had to grow up a bit

    Sony suffered a chorus of disapproval after it withdrew 'The Interview', but it's not too late for it to take a stand, says Joan Smith
    From Widow Twankey to Mother Goose, how do the men who play panto dames get themselves ready for the performance of a lifetime?

    Panto dames: before and after

    From Widow Twankey to Mother Goose, how do the men who play panto dames get themselves ready for the performance of a lifetime?
    Thirties murder mystery novel is surprise runaway Christmas hit

    Thirties murder mystery novel is surprise runaway Christmas hit

    Booksellers say readers are turning away from dark modern thrillers and back to the golden age of crime writing
    Anne-Marie Huby: 'Charities deserve the best,' says founder of JustGiving

    Anne-Marie Huby: 'Charities deserve the best'

    Ten million of us have used the JustGiving website to donate to good causes. Its co-founder says that being dynamic is as important as being kind
    The botanist who hunts for giant trees at Kew Gardens

    The man who hunts giants

    A Kew Gardens botanist has found 25 new large tree species - and he's sure there are more out there
    The 12 ways of Christmas: Spare a thought for those who will be working to keep others safe during the festive season

    The 12 ways of Christmas

    We speak to a dozen people who will be working to keep others safe, happy and healthy over the holidays
    Birdwatching men have a lot in common with their feathered friends, new study shows

    The male exhibits strange behaviour

    A new study shows that birdwatching men have a lot in common with their feathered friends...
    Diaries of Evelyn Waugh, Virginia Woolf and Noël Coward reveal how they coped with the December blues

    Famous diaries: Christmas week in history

    Noël Coward parties into the night, Alan Clark bemoans the cost of servants, Evelyn Waugh ponders his drinking…
    From noble to narky, the fall of the open letter

    From noble to narky, the fall of the open letter

    The great tradition of St Paul and Zola reached its nadir with a hungry worker's rant to Russell Brand, says DJ Taylor
    A Christmas ghost story by Alison Moore: A prodigal daughter has a breakthrough

    A Christmas ghost story by Alison Moore

    The story was published earlier this month in 'Poor Souls' Light: Seven Curious Tales'
    Marian Keyes: The author on her pre-approved Christmas, true love's parking implications and living in the moment

    Marian Keyes

    The author on her pre-approved Christmas, true love's parking implications and living in the moment
    Bill Granger recipes: Our chef creates an Italian-inspired fish feast for Christmas Eve

    Bill Granger's Christmas Eve fish feast

    Bill's Italian friends introduced him to the Roman Catholic custom of a lavish fish supper on Christmas Eve. Here, he gives the tradition his own spin…
    Liverpool vs Arsenal: Brendan Rodgers is fighting for his reputation

    Rodgers fights for his reputation

    Liverpool manager tries to stay on his feet despite waves of criticism
    Amir Khan: 'The Taliban can threaten me but I must speak out... innocent kids, killed over nothing. It’s sick in the mind'

    Amir Khan attacks the Taliban

    'They can threaten me but I must speak out... innocent kids, killed over nothing. It’s sick in the mind'
    Michael Calvin: Sepp Blatter is my man of the year in sport. Bring on 2015, quick

    Michael Calvin's Last Word

    Sepp Blatter is my man of the year in sport. Bring on 2015, quick