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‘Little Wonder!’ Here’s The ‘Bad News’ About Earnings

"Outside of a crisis, changes in share prices and earnings highly correlate, and no more so than today."

Just a quick note on something we happened to glance at this evening.

So there’s good news and bad news as we head into Q3 earnings season. The good news is that earnings have been, well, good. The bad news is, y/y earnings growth is expected to be subdued this quarter and on top of that, sensitivity to earnings is even higher than usual. We’ll get to that latter, bolded point in a second, but first, recall this very simple chart from Goldman:

Exhibit

From “bigly” in Q1 and Q2 to not so “bigly” in Q3. As you can see in the chart, some of that is base effect, so take that into consideration. Here’s the breakdown:

Exibit2

Ok, but you probably already knew that if you read our week ahead preview or if you are a person who is generally paying attention to what’s going on (a rare breed these days, especially among retail investors).

Well here’s something you probably didn’t know. Consider the following brief excerpts from the latest note by SocGen’s Andrew Lapthorne:

So the good news is profits are coming through and this is pushing equities higher. The bad news is that sensitivity to earnings is even higher than usual, leaving the market more vulnerable to disappointments.

The coincident sensitivity of EPS and price changes is reflected in the chart below. This represents the cross-sectional relationship between annual stock EPS changes and stock price changes over the same period. We measure this by ranking stocks into deciles based on prior EPS changes and measure the r-squared across these deciles versus price change. Outside of a crisis, changes in share prices and earnings highly correlate, and no more so than today – little wonder then the obsession with short-term profits!

EarningsSensitivity

Yes, “little wonder” that we all live under the tyranny of the next earnings report!

And, if you just extrapolate from that a little bit, “little wonder” the allure of financial engineering. Because what better way to boost EPS than by artificially inflating the bottom line with debt-financed buybacks?

[Note: we don’t want to misrepresent Andrew’s work here. His latest note – from which the excerpts above are taken – is actually more upbeat than we’re letting on. And indeed, it’s more upbeat than most of his weekly missives. In short: things aren’t all bad.]

 

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