Earnings Cheating Season: Is Your Favorite Company Cooking the Books?

Courtesy of Mish.

In his latest Global Strategy Report, Albert Edwards at Societe Generale discusses "earnings season" which he calls "cheating season".

We have always found that swings in analyst earnings expectations mirror the economic cycle quite well, but because of the weekly frequency, swings in analyst earnings optimism often act as a timely leading indicator for the economic cycle. If that is still the case, the recent data for the US should be worrying. Despite the soothing Q3 headline earnings reports as US companies ‘game’ the system, all is not well once you look into the ‘MUC’ (Manipulated Underperforms Conservative).

Remember the so-called Fed model? We were told that the extraordinarily high PEs were justified by low bond yields. The key plank of the Ice Age theory was that this positive correlation would break down and that equities would de-rate in absolute and relative terms compared to government bonds thereby inverting the close positive correlation between bond and equity yields.

What this also means is that in an Ice Age world, the equity cycle will more closely correlate with economic and profits cycles. Most correlation analysis finds virtually no post-war relationship between economic growth and the stock market.

But, this does not hold true during the Ice Age. Indeed, we knew from Japan that the equity market would start to track the economic and earnings cycle closely.

In the Ice Age, equity investors need to pay close attention to economic and earnings cycles and not be comforted by lower bond yields. If that is the case equity investors should be getting nervous NOW as earnings optimism starts to fall away sharply.

Earnings Upgrades vs. Downgrades as Percentage of Changes

We have long believed that the US reporting season should in fact be called the US cheating season as companies game the market to ramp earnings down ahead of company announcements only to beat analysts estimates by 1¢ on the day!

Apparently companies believe the feel-good news headlines of a earnings beat will offset the negative impact of downward guidance ahead of the report. In fact the evidence suggests otherwise: my colleague Andrew Lapthorne has shown that those companies that engage in earnings manipulation underperform those that do not. He developed a very useful MUC Score, Manipulated Underperforms Conservative.

(An update of the MUC is being delayed while Andrew works on an update of a more comprehensive earnings quality score, formally called the cheating, or C-score. Developed by my former colleague James Montier, Andrew changed the name as companies got mighty shirty when they appeared on this list!)

I rely on Andrew for this timely weekly data which he highlights every Monday in the Global Equity Market Arithmetic….

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