US Earnings Season: The Earnings' Surprise Myth Exposed

Based on the earnings releases so far in the S&P 500 earnings surprises are a bad predictor for two-day excess return around the earnings release with Advanced Macro Devices the prime example.

Earnings surprise means little
Contrary to the prevailing myth, also reinforced by the media, that earnings surprises are everything, our findings crush this myth. Based on the first 103 earnings releases in this Q2 earnings season, the following relationship between the earnings surprises and the two-day excess return emerges (see chart below).

There exists indeed a positive relationship meaning that a higher earnings surprise leads to higher excess return and vice versa. The problem is just that the R-squared is only 0.09. In other words, the earnings surprise only explains nine percent of the variation in the excess return. So even if you were the best earnings forecaster in the world you would not be able to make consistent trading profits.

The missing piece is likely a mix of factors with the forward guidance and management statements likely explaining a lot of the variation in the excess return. AMD's recent earnings release is a good example.

AMD reported a 27.4 percent earnings surprise but has an 8.6 percent negative excess return. Why? Interestingly, AMD actually forecasts Q3 revenue of USD 1.38-1.45 billion compared to estimates of USD 1.23 billion, which on the margin is very positive, but the company revised down their gross margin to 36 percent from 40 percent eating away the profits of its new business. So here is an example of positive surprises but it is the said things between the lines that ultimately drives the share performance.

Q2 loser Microsoft
With 20.6 percent of the S&P 500 companies having reported Q2 earnings, corresponding to 31.7 percent of the market capitalisation, we are getting closer to meaningful conclusions about the winners and losers on individual and sector basis. Over the coming days we will write extensively about the US earnings season. Later this week our analytical focus will shift to Europe and compare the two continents.

Since our Friday update on US earnings season, new losers and winners have emerged. The biggest loser in this earnings season is now Microsoft down 12.8 percent, measured by the two-day excess return relative to S&P 500, driven by weak earnings release no matter if the surface inventory write-down is included or not. The only part of Microsoft that is still humming like a sports car is the enterprise division while everything consumer-related is destroying shareholder value. The question should soon be whether Microsoft should retreat to a less publicly visible life and concentrate on milking the corporate sector through its extensive suite of professional enterprise solutions.

Among the top performers, Johnson Controls has emerged as the new winner with an impressive 9.0 percent excess return as the turnaround is beginning to pay off for the company. In addition the company raised its fiscal year adjusted EPS to 2.64-2.66 which is a bit higher than the Street's estimate of 2.60.