Stocks: The Truth Behind Wall Street's Earnings Game

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As we head into earnings season -- non-official "starter" Alcoa reported after the close -- investors bid U.S. stocks up today, with the S&P 500 and the narrower, price-weighted Dow Jones Industrial Average gaining 0.5% and 0.6%, respectively.

Consistent with those gains, the CBOE Volatility Index (VIX) , Wall Street's "fear index," fell roughly 1% to close at 14.78, its lowest closing level since May 30. (The VIX is calculated from S&P 500 option prices and reflects investor expectations for stock market volatility over the coming 30 days.)

Follow-up: Dell
Last Friday, I mentioned that Dell's board had gone back to the well (or Dell, in this case) to try to squeeze a few pennies (dollars?) more from Michael Dell and his buyout partner, Silver Lake Partners. Mr. Dell was reportedly having none of it, considering that his $13.65-per-share offer is generous enough. Today, Mr. Dell and Silver Lake won a victory in the battle for Dell, as ISS, the largest proxy advisor, backed their acquisition, arguing that:

The risk may be less that he's taking all the upside for himself than that he is trying to catch a falling knife. From a public company shareholder's perspective, if your CEO is willing to buy your falling knife for the privilege of catching it, there is probably a price at which you should let him.


Perhaps, but one look at Dell's five-year stock chart is enough to wonder if the offer really amounts to catching a falling a knife. I submit that Mr. Dell and Silver Lake may instead be picking up off the sidewalk a knife that had already fallen:

DELL Chart

DELL data by YCharts

The macro view: The earnings game starts now!
Alcoa reported this afternoon, kicking off the earnings season ... and another episode of the earnings game. Here's how Wall Street played the earnings game last quarter (it's an instructive case study, since this quarter is shaping up exactly the same way): A year or more in advance, analysts publish absurdly aggressive estimates, and those estimates are periodically revised downward over the next 12 months. The downward revisions accelerate as the quarter in question draws near, sufficiently so the companies can ultimately beat the estimates. The "beats" mask lackluster earnings growth.

Consider, for example, that the bottom-up estimate for the S&P 500's operating earnings per share for this past quarter has come down roughly 10% since the end of March 2012, and roughly 4% since the end of last March. If the companies in the S&P 500 achieve the $26.40 consensus estimate for the second quarter, it won't even amount to 4% year-on-year earnings-per-share growth. That's not a disastrous result by any means, but it's hardly the stuff that premium multiples are made of.

The S&P 500's operating earnings per share for the 12 months to March 2013 grew an anemic 0.2%. With the index priced at 15 times the (inflated) earnings-per-share estimate for 2013, the burden of proof is on those who say stocks are cheap.

With U.S. stocks reaching new highs despite lackluster earnings growth, looking for selective growth opportunities will pay off. Many global regions are still stuck in neutral, and their resurgence could result in windfall profits for select companies. A recent Motley Fool report, "3 Strong Buys for a Global Economic Recovery," outlines three companies that could take off when the global economy gains steam. Click here to read the full report!

The article Stocks: The Truth Behind Wall Street's Earnings Game originally appeared on Fool.com.

Fool contributor Alex Dumortier, CFA, has no position in any stocks mentioned; you can follow him on LinkedIn. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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