Low Expectations and Surprises

Most days in Oregon, all we expect to see are clouds and rain, it doesn't matter if it is December or July. In fact, I can’t really remember a 4th of July without clouds and some rain. I know we have had them, but it's just that I've grown to expect clouds and rain.

That's why when we see sunshine, blue skies, and all the green trees, it’s always a welcome surprise even in the middle of August. Mother Nature has a way of managing our weather expectations here in Oregon.

Not unlike Oregon weather, our economy and broad markets have most of us expecting some pretty gray clouds—and not for bad reason with Europe's banking and fiscal debt crisis. On top of this is our own fiscal crisis as well as a slowdown in China, India, and other countries.

Like Oregon weather, no one really has a perfect macro picture of what to predict in the future for the markets. In fact, you might find it a bit of a surprise to see companies beating estimates set by the “sell-side” analysts, and there’s a big reason why these surprises sometimes happen. Sell-side analysts have an incentive to follow along with the Wall Street consensus when it comes to making estimates. If one of them makes a dissenting call and turns out to be wrong, that could mean lost revenue from fewer research subscriptions or fewer trades routed through that analyst’s trading department. If they go along with the pack and the overall Wall Street consensus is wrong, then they can simply say, “Well, everyone else was wrong also!”

So, analyst’s estimates tend not to differ too much from the overall consensus—so when a surprise happens, markets can move.

This is a Bloomberg graph of analyst estimates for the quarterly earnings on S&P 500 companies (orange line) versus actual quarterly earnings (white line) for the period of June 2011 to June 2012. As you can see, estimates often do not get revised until there is a big swing either up or down—after the surprise has already happened.

Conclusion

Considering a 7.07% pullback in the S&P 500 (Bloomberg) since the start of the quarter, there are two possibilities: either the broad markets are forecasting some tough times ahead--which is very possible--or this is an overreaction and companies are earning stronger numbers than the low expectations set by the Wall Street crowd.

It is impossible to predict with 100 percent certainty. That's why we see the markets move in very brief bursts, and if you miss just a few days you could miss all the advantage. As we have written before in our July 5, 2011 blog post, missing only a handful of the best days of the market (which often occur immediately after the worst days) can have a very significant impact on performance.

Most of those bursts come when expectations are very low and a surprise positive catalyst, causes a rush to get in.

Tim Phillips – CEO, Phillips & Company

Research supported by Alex Cook – Associate Investment Advisor