Moneyball – The Wall Street Edition

Posted by David Nelson, CFA on July 18, 2022 in Investment Management | Leave a comment

By David Nelson, CFA CMT

Earnings season is an expectations game. I use the word game because in many ways that’s just what it is. Every sport has analysts who crunch the data coming up with point spreads, player health, weather, etc. Some are even able to make an informed guess on whether the runner on first is going try to steal second when the count is 3 & 2. $Billions are won and lost based on the outcome.

Wall Street has their team of analysts and its own version of Moneyball. Crunching millions of bits of data, they come up with an informed judgement on how these companies are going to perform over a given quarter. Most give you a price target on where the stock is going to be 12 months from now.

In football by halftime, you have a pretty good indication on how the game is going. If you’re a bookie taking in bets you might lay off some of your risk if the odds are turning against you. Wall Street is no different and with the passage of time stock analysts adjust their estimates to changing conditions and their clients make trading decisions based on the new information. As an analyst and on the line portfolio manager I can tell you that estimate revision is one of the more successful factors in stock selection.

Rule #1

Data by Bloomberg

Games have rules and the Game of Stocks is no different. Over the long run stocks follow earnings. The high correlation between price performance and earnings estimates can’t be overlooked. 

One of these two lines is wrong

Data by Bloomberg

Therein lies the problem. For most of the year there has been a noticeable disconnect between analyst estimates and stock prices. So much so that even the media has picked up on the spread. Until very recently estimates for the S&P 500 pushed higher almost weekly even while stocks cratered into a bear market.

What are these analysts looking at that stock investors can’t see? These same analysts didn’t seem to have any trouble cutting targets as they have been slashing them for over a month. However, estimates have only just started to roll over.

Data by Bloomberg

If we dig further into the data, we can see some sectors will still see growth for obvious reasons. The S&P 500 Energy Sector is looking at +71% growth on a fiscal basis. However, even today after jumping +286% off the COVID low, energy stocks represent just over 4% of the S&P 500 market cap. So, while this is a positive, it can only add so much.

Healthcare, another example is largely defensive and has secular tailwinds. It’s been something of a safe haven and one of the few sectors still positive on a trailing 1-year basis.

Let’s dig deeper.

Just about the only sector where analysts are expecting year over year earning’s declines is Financials at -6.9%. Coming into the year the glass was half full as banks were expected to be a direct beneficiary of FOMC rate hikes to bring down inflation expectations. Six months later the bigger fear is recession.

Citigroup Earnings vs Consensus Estimates

Data by Bloomberg

If you don’t think expectations play a role take a look at the outsized performance of Citigroup (C) on Friday. Beating by a country mile with a mid-single digit PE Citigroup topped estimates by over +28%. Citi exploded off of a 52-week low jumping +13.23% sparking a major move in financial stocks dragging the rest of the market with it. The S&P closed up +1.62% ending the week lower by -0.91%. It’s important to point out that an earnings release isn’t just a report card on the company. It’s also a report card on how good or bad the analysts were at getting the number right. In the case of Citi they obviously got it wrong. 

Data by Bloomberg

Consumer discretionary despite all the challenges is still expected to see a big year on year earnings bump. Amazon (AMZN) & Tesla (TSLA) represent over 42% of the Consumer Discretionary Sector. Analysts project Amazon to have an earnings drop of about -20% ending the year with a consensus number of $1.85 in EPS vs last year’s $2.33.

Data by Bloomberg

Making up some of that shortfall is Tesla. With a market cap of $746 Billion it is 35% smaller than Amazon but is expected to deliver $11.75 EPS by year end up 141% from last year’s $4.86.

Technology 

Perhaps the biggest disconnect is Technology still estimated +17% year on year growth. In the face of well documented supply chain challenges and the pull forward of covid induced demand for items like laptops and electronic devices, estimates seem out of step with current economic conditions.

Semiconductor Stocks have been pricing in a downturn all year

Data by Bloomberg

That seems to be changing. Barron’s reports that Goldman’s semi-conductor analyst Toshiya Hari slashed his calendar 2023 estimates by about 20% to better reflect the current macro enviornment.

We need this. Stocks are a good leading indicator. The widening gap between current estimates and prices adds risk to the overall market. Look at the S&P 500 chart with price and earnings estimates. One of those two lines is wrong.

Once we get estimates down to reality, we can go back to playing the game we know and love. With a market cap that represents 27% of the S&P 500 it’s imperative that disappointments in technology are contained. That becomes increasingly difficult if analysts hold onto stale estimates.

Like I said earlier, games have rules and Rule #2 in Wall Street Moneyball is beating expectations is important.

There are analysts like Mr. Hari willing to make the tough calls but unfortunately there are still too many waiting for management to tell them what to do.

*At the time of this post some funds managed by David were long AMZN and XLE