Get Ready for Earnings Season – Wall Street's Quarterly Shell Game

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It's earnings season. In fact it's prime time for companies' first-quarter earnings.

For company players the game is about trying to beat analysts' estimates, to get your company's stock to pop so you look better than your reflection.

But, the game is rigged.

What! Another rigged game on the purposely muddied fields where Wall Streeters play?

Yep. Another rigged game.

And like high-frequency trading (HFT) and so many other "institutionalized" games on the Street that are sucking the life out of other people's dreams, it's not illegal.

This is the norm...

The game is called managed earnings, or managing earnings.

The most successful gamers play with a gusto that crosses over the legal border. They juggle their books to shove losses and profits into columns, drawers, and boxes depending on what their objective is for that particular accounting period.

Maybe they made too much money and want to hide some for another quarter where they don't make what analysts expect. Maybe they bury losses somewhere so they don't look as bad in a reporting quarter.

It's about manipulation.

Earnings Season

That part of the game is illegal. But because it's merely accounting hocus pocus, the worst a company gets - when the facade of its magic show is blown - is a slap on the wrist.

If you want a history of how to play this part of the game to perfection, look how General Electric under Jack Welch, performed - I mean managed - their earnings. All I'll say is you just can't have your earnings come out to the penny quarter after quarter after quarter without internal prestidigitation.

While that locker room game is for seasoned pros, every company plays the field game.

On the field it's all about what analysts' estimates are.

If your company earnings beat what analysts expect, you're a winner. If your earnings fall short, you're a loser and so is your stock.

And where do these highly touted Wall Street analysts get their estimates from?

I'll tell you where, but you're not going to believe it...

They do their homework and study the company's business and sales and margins and everything else they have to look at to determine what they think a company is going to be earning that quarter.

Oh, and they talk to the company.

That's the real game: Talking to the company... And getting their take on their earnings.

For heaven's sake if all your big shot peers are putting out earnings estimates you don't want to be the only one who is wrong! That's why they all talk to the companies they cover.

It's a mutually beneficial game, for the most part. The analysts don't want to be too off the mark and companies want their earnings to come out better than the analysts' consensus estimates.

Of course companies don't want their earnings to be a negative surprise and come out far below the consensus. If that happens their stock gets clobbered. And that does happen - but not why you think.

The game for companies is to "guide" analysts they talk to. If they're having a bad quarter relative to a year ago and everyone is thinking they're doing well, their job is to guide analysts' expectations down. That's right, they tell analysts things aren't as good as they'd expected or hoped for. Then all the analysts, who don't want to look stupid, ratchet down their earnings estimates right before the company reports.

And presto! When earnings come out, miraculously, they "beat" consensus estimates and their stock pops higher.

It's manipulation. But it's not illegal.

The problem is that average investors don't understand the game. Earnings come out and they're better than the consensus, things must be good, right? Maybe.

What gets lost in translation is how much the analysts were guided. It's a regular phenomenon: Consensus estimates fall right before earnings reports come out.

The analysts should not be able to speak with the companies they cover. If the company wants to guide earnings expectations lower, they should post an SEC-filed statement for analysts to follow and the public sees for themselves.

Then when earnings come out, analysts should report their original earnings based on their estimates and the difference between original estimates and their ratcheted-down estimates.

News reports should have to display analysts' original consensus estimates at the beginning of the quarter and latest estimates and calculate the increase or decrease in the consensus. That way the public can see how the company did over the quarter relative to how it was expected to do - before it guided analysts' consensus estimates down WITHOUT TELLING THE INVESTING PUBLIC.

So far this quarter, the first quarter of 2014, analysts have lowered their growth estimates from the beginning of the quarter to right before companies started reporting by 5.6 percentage points.

Did you know that? Did you know that earnings estimates had been guided down so much? I doubt it. No one announces that. It's just an adjustment between the analysts and the companies they cover.

I'm not even going to get into how most of the big bank analysts don't just cover these companies... they work for them. On Wall Street they call that a symbiotic relationship.

So, how come companies miss ratcheted-down estimates and have to endure their stocks dropping as a result? Because if companies actually guided down enough they'd be torn between letting the cat out of the bag early and seeing unwanted headline news clobber their stock. They'd rather hope and pray the market will be strong when their crappy earnings come out and their stock will get lifted in a general euphoria.

It's a dirty game. It should be cleaned up.

More from Shah Gilani: The growing threat to capitalism is "socialism for the rich" - and it's the new normal. And there's only one thing that can put a stop to it...

About the Author

Shah Gilani is the Event Trading Specialist for Money Map Press. He provides specific trading recommendations in Capital Wave Forecast, where he predicts gigantic "waves" of money forming and shows you how to play them for the biggest gains. In Short-Side Fortunes, Shah shows the "little guy" how to make massive size gains – sometimes in a single day – by flipping large asset classes like stocks, bonds, commodities, ETFs and more. He also writes our most talked-about publication, Wall Street Insights & Indictments, where he reveals how Wall Street's high-stakes game is really played.

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