Why Weak Earnings Today Could Turn the Bulls Loose Tomorrow

Keith Fitz-Gerald

Everybody is hoping for a swell earnings season on the assumption that it will help the markets move higher.

However, if history is any guide, weaker earnings may be just what the doctor ordered.

Here's why.

Obviously we don't want a disastrous set of numbers, but downbeat earnings and guidance actually creates the possibility of more positive surprises that will encourage money to move into the markets instead of away from them.

Think of it this way: When things shift from good to bad there's a distinct aversion to risk and assets flee like they did following the "dot.bomb" blowup in early 2000 and at the onset of the financial crisis in 2007.

But when they go from bad to less-bad, it's human nature to assume things are improving. And that sentiment brings out the bargain hunter in all of us while also drawing money into the markets. That was the case in mid-2002 and just after March 2009, when people were hoping for something - anything really - to get the juices flowing again.

Winning the Expectations Game

Wall Street understands this psychology better than you might imagine. That's why m anipulating earnings and analyst expectations is a science in and of itself.

Everybody denies it happens, but ask nearly any seasoned Wall Streeter and you'll get a sideways glance and a knowing smile.

The wall that supposedly separates the research, investment banking, brokerage and trading functions of any given firm is a plumber's worse nightmare, depending on your perspective.

Former analyst Stephen McClellan notes in his book "Full of Bull" that this is how the game is played.

He says that's why it's important to do what Wall Street does rather than what it says as a means of securing your personal profits.

I couldn't agree more.

Having spent more than 20 years closely involved with the markets, I've learned that Wall Street's blinders, miscues, set-ups and secrets are often more telling than the "telling" itself.

Consider what's happening right now.

According to Standard & Poor's, analysts have raised projections for 366 companies while lowering those associated with another 534 companies. In other words, lowered expectations out number rising expectations by almost 2:1. Bespoke Investment Group notes that all ten S&P sectors have had more negative revisions than positive.

That's in stark contrast to two years ago when analysts were positive at the onset of 2010 for roughly 80% of the market with the exception of healthcare and utilities. Both were viewed as little more than bastard children and cast as negative performers.

As you might expect, many investors bailed out of the latter while rushing into the former. But that turned out to be a mistake -- healthcare and utilities were the best performing sectors in 2011.

This doesn't always happen, but it's well documented that Wall Street often says one thing and does another. You'd think at this stage of the game things would be different, but they're not.

Take the Facebook IPO, which is widely believed to be imminent...

Last year, the firm made headlines with a quasi-private version of the offering with sales to private clients that imply a preposterous value of between $50 billion and $100 billion. And, right there in black and white, in the fine print it says that Goldman Sachs Group Inc. (NYSE: GS) may trade directly against its clients without warning and without recourse to the very investors they supposedly represent.

The lines are very clear here. Professionals know that supposedly independent research is often misleading at best and completely contradictory at worst. Notes McClellan, "transaction-oriented Wall Street, unfortunately, tends to discourage and even hinder proper investing."

A Chance to Outsmart Wall Street

So what does this earnings season suggest about the future?

I think Wall Street is trying to set the bar low, and even though valuations are not optimal, pullbacks represent buying opportunities - especially in areas that Wall Street dislikes such as energy, inflation resistant investments, and commodities.

I expect a lot of companies to set forth lowered guidance this year while trying to discourage gleeful thinking about the recovery. That way they can sweep back in with above-board surprises a quarter or two from now, having already built the gains that will occur then on the 19 consecutive weeks of outflows in equity funds happening now.

I also believe Wall Street is all too aware that 2011 was one of the worst years in recent memory. Nearly 60% of all hedge funds lost money, according to preliminary data from the HedgeFund Intelligence Database. Big or small, it didn't matter.

Noted billionaire hedge fund manager John Paulson - you know, the guy who reaped billions for his "Big Short" against the subprime markets - is reportedly down 51% in one of his biggest funds. You know that's gotta hurt and give him every motivation to get even.

Not surprisingly, bonuses, thanks to poor performance, were down significantly.

For example, a few years back, many senior Goldman partners reportedly took home $6 million or more. The payout last year was $3 million, according to CNBC.

I know...I know...cry me a river. I feel the same way.

But here's the interesting part. Overall compensation as a percentage of revenue is rising. This means that revenue also is falling.

Back to Goldman. In 2010, compensation as a percentage of firm revenue was 39.3%. According to CLSA (as reported by CNBC), this figure is now 44%. In other words, revenues have dropped, making the same payout a bigger piece of a smaller pie.

How much smaller? That remains to be seen, but in Goldman's case, firm revenues are expected to have declined by 22%, while profit may have dropped more than 7%. We'll know what the exact figures are on Jan. 18 when Goldman reports before the opening bell.

R eports also suggest that Morgan Stanley (NYSE: MS) employees may see bonus payout declines of 30-40%. Things are evidently so bad that Jefferies Group Inc. (NYSE: JEF) employees are threatening to quit if bonuses are not up to snuff.

This is very simple -- Wall Street is hurting ,which is why better-than-expected results a quarter from now may be precisely the prescription needed to get all that money back into the markets...again.

So view pullbacks with caution, but eye them for what lowered earnings suggest they may be - a chance to outsmart Wall Street at its own game and a chance to buy early.

When everybody else finally gets the message that things are "improving" and piles in, that will be the time to sell and repeat the cycle all over again.

You don't have to be whipsawed by the temporary swoon it would seem they want to create.

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Keith Fitz-Gerald

About the Author

Browse Keith's articles | View Keith's research services

Keith is a seasoned market analyst and professional trader with more than 37 years of global experience. He is one of very few experts to correctly see both the dot.bomb crisis and the ongoing financial crisis coming ahead of time - and one of even fewer to help millions of investors around the world successfully navigate them both. Forbes hailed him as a "Market Visionary." He is a regular on FOX Business News and Yahoo! Finance, and his observations have been featured in Bloomberg, The Wall Street Journal, WIRED, and MarketWatch. Keith previously led The Money Map Report, Money Map's flagship newsletter, as Chief Investment Strategist, from 20007 to 2020. Keith holds a BS in management and finance from Skidmore College and an MS in international finance (with a focus on Japanese business science) from Chaminade University. He regularly travels the world in search of investment opportunities others don't yet see or understand.

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