Whispers, routines and the rites of spring: a statiscal analysis. Gordon Fowler Jr. is CIO of Glenmede Trust Company, an independent wealth advisory based in Philadelphia.

Summary

Quarterly earnings season is almost upon us again. A successful earnings season is measured by whether companies provide more positive than negative surprises.
Glenmede’s proprietary Whisper Signal Model for earnings surprises anticipates that we will have another good season; leading, we hope, to higher market levels.
It should also be noted, however, that the number of negative surprises is expected to increase and will influence the headlines.
This week’s commentary concludes with a rigorous analysis of the risk-return of being a Philadelphia sports fan.

Review and outlook

The first quarter is over. That means we are approaching earnings season once again. Earnings season is the quarterly ritual that drives the investment news cycle for a three-to-five-week period. During this time, hopes are either justified by management reports on corporate earnings conditions, or they are dashed by disappointing news. Our guess – bolstered by our forecasting models – is that this will be another good quarter for earnings announcements. It is expected, however, to be “less good” than prior periods.

The market didn’t trade last week with any sense of joyous expectation. The broad stock market, as measured by the S&P 500, fell by 0.3%, led by declines in utilities (down 1.8%) and materials (down 0.7%). The gainers for the week were telecoms (up 0.8%) and energy (up 0.3%). Small-cap companies, as measured by the Russell 2000, had a good week, rising by 1.1%. Foreign investments declined in value by 0.2%, as measured by the MSCI EAFE index. The decline was entirely attributable to a stronger dollar; local markets actually rose in value by 1.1%.

Selected Asset Class ReturnsWeekly and Year to Date

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Google was added to the S&P 500; otherwise there was very little coprporate news last week. The most interesting economic data were the housing numbers. Existing home re-sales rose in February by 5.2%, while new home sales fell by 10.5%. There may be some timing differences that explain this odd result. This mixed result, however, might also be symptomatic of a market that is going through an adjustment rather than a collapse.

Housing prices simply have risen too much and now buyers are resisting the current price levels. Somewhat higher long-term rates and significantly higher short-term rates have made purchase prices less affordable for the marginal buyer. But are people going to stop buying and selling houses forever? Probably not: but housing prices or, to be more exact, land prices, will need to go through a period of downward adjustments to bring prices back into line. The correction in many geographic areas does not need to be severe. In may be just as simple as a narrowing of the spread between the existing bid and ask. Demographics and decent employment growth may well partially offset a portion of this decline in demand.

The vagaries of the housing market will likely take a back seat over the next few weeks to the three-monthly show that regularly grips the attention of all long-term investors – I mean, of course, the quarterly earnings results.

Season of hope

Earnings seasons seem to follow a pattern. It starts when a few significant companies pre-announce disappointing results. This is followed by public hand-wringing about corporate America’s period of strong earnings growth having come to an end. Toward the end of earnings season, however, the results are tallied, and things turn out not so bad. The measure of success or failure of an earnings season is whether analysts are pleasantly surprised by the results that they see and subsequently revise their forecasts up a bit for the following quarters and years.

Getting a feel for the rough number of positive surprises is a good way to predict if we will have a good earnings season. One tool that Glenmede uses to judge the earnings environment is our proprietary Whisper Signal Model. This looks at the earnings forecasts for individual stocks made by individual analysts on Wall Street. Some analysts are better than others at anticipating the direction of future earnings. The Whisper Signal Model figures out who those analysts are and uses the direction of their forecast changes and other factors to forecast whether a stock is going to produce a surprisingly strong upward revision in the next quarter or a surprisingly poor number. This information can be useful when buying and selling individual stocks.

It is also useful to look at the total number of stocks in the S&P 500 where we expect strong upward surprises and compare it to the number of stocks where we anticipate downward surprises. This ratio can give us an idea as to whether we should expect a strong or weak earnings season.

And what do the numbers tell us? As shown in the chart below the number of stocks in the S&P 500 that are strong candidates for positive surprises exceeds the number of strong negative candidates by a two to one margin. This bodes well for the upcoming earnings season. There is a small caveat to be mentioned here. This ratio of good to bad has declined over the past year. As companies enjoy more and more profitability, the bar is raised, and it gets harder and harder to jump over the bar.

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Why is this? Well, it’s worth looking again at our favorite chart on earnings. The picture below shows S&P 500 earnings versus long-term trend growth. Earnings are still anticipated to rise, but they are now, and will be over the near future, well above trend line. This reflects the fact that companies are earning very high profit margins. Earnings may continue to grow from here as the economy grows, but earnings growth from increasing profitability (or earning an increasing amount on every additional dollar of sales) will be difficult.

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At some point, this profitability level will go back to normal, and earnings will return to trend line. Until then, we suspect the market will continue to cruise as good earnings news fulfills the hopes and dreams of long-term investors during quarterly earnings season.

Season of despair

The first pitch of the Major League Baseball coincides roughly with the start of earnings season, and I am in the process of applying for dual citizenship. As a son of New England, I am a devout partisan of the Boston Red Sox. Please don’t doubt my level of loyalty to the teams from my birthplace. I maintained that partisanship through twenty (often painful) years of living in the suburbs of New York. For a Boston sports fan, it is far easier to pick up support for Philadelphia teams than New York teams. There is one important point of commonality: a shared experience of despair. One concern I have about becoming a Philadelphia sports fan is that the feeling of despair has gone to excess. One senses from conversation and from the local media a feeling of gross injustice. Philadelphia, though it has had many great and heroic teams over the past forty years, has been deprived its fair share of champions. The area has had good teams that get close but never realize greatness and national acclaim.

I have never really wanted to join a sports community with a brooding sense of injustice. Spectator sports for me are a way to escape from life’s problems – not a place to repeat them. I want teams that I can dream about. I do not want to join a collective nightmare. So before I signed up as a Philadelphia sports fan, I decided to do some analytical research and see whether this sense of inequity had any validity. Specifically, I took a list of the ten largest metropolitan areas in the U.S. and counted how many times a professional team in one of the four major professional spectator sports (baseball, football, basketball and hockey) won a national championship since 1960 in each of these metropolitan areas.

As it turns out, Philadelphia has reason to despair. Out of the top ten metropolitan areas in America, it ranks 8 out of 10 in terms of number of championship teams. Only Dallas and Houston, areas that would barely have ranked as metropolises in 1960, come in below Philadelphia.

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There is an interesting observation that goes with the results of this table. Market size and number of championship teams is highly correlated. The correlation coefficient between these two rankings – size and wins – is 0.76. Just to put that in perspective, a correlation of 1.0 would mean that the two series are perfectly correlated.

This makes some sense. Larger markets have more teams and more money to spend on good players. With that observation in mind, Philadelphia’s result is far more logical. It is the sixth largest metropolis in the country, and it ranks eighth in terms of number of championships. To be fair, Philadelphia still has a case. The ranking by championships is two below the ranking by market size. But Chicago and the Washington-Baltimore area which earned have fewer championships than one would expect given their sizes, share the same fate. Chicago fans, in particular, love their Cubbies even if the team seems never even to make the playoffs. Chicago just shrugs its broad shoulders and doesn’t moan about its victimization at the hands of hateful sports gods. In a city where a cup of coffee spilled outside during the winter can freeze before it hits the ground, the phrase “deal with it” is not just an empty comment; it is a means of survival.

The table does reveal one disturbing fact. There is one metropolitan area and fan base that has no right to complain. Sitting only second to New York in terms of accumulated championships is a metropolitan area than ranks seventh in terms of size. Given its size, it has had a disproportionate share of ticker tape parades. Its fan base has no right to utter a complaint that the fates have conspired against them. And if there is any statistical validity to my model, the region should fail to win anything close to its fair share of championships over the next thirty years. That city is…um, well… Boston. –FWR

Review & Outlook is intended to be an unconstrained review of issues, topics and considerations of possible interest to Glenmede's clients and is not intended to be applicable to any one particular client. Actual investment decisions for particular clients are made in light of applicable considerations and may be different from the views expressed here. Likewise, actual portfolio performance may differ from the results discussed.

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