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Something hasn't seemed quite right to me since the second quarter started. I couldn't put my finger on it for a long time. Then Apple (Nasdaq: AAPL ) reported earnings yesterday, and everything fell into place.
Apple rarely misses its estimates. Even as a recession kicked into high gear four years ago, Apple kept beating the Street. However, a number of public companies didn't, which resulted in the highest level of negative earnings surprises in a decade. We're approaching the same level today. Let's dig deeper into this ominous indicator to find out why you should be on your guard against another big downturn.
There aren't a lot of analysts tracking earnings surprises across the entire market, so it can be easier to overlook the big picture and instead focus on weakness from company to company. Part of this puzzle fell into place for me when I stumbled across an excellent Business Insider chart-a-thon that contained a long-term look at EPS surprises by Richard Bernstein Advisors.
A quick note here: EPS surprises are simply a company's outperformance or underperformance compared to analysts' estimates for its quarterly earnings per share. In 1992, companies on the S&P 500 (INDEX: ^GSPC ) had roughly equal amounts of positive and negative surprises. But ever since, the game has been all about beating estimates, and positive surprises have been the norm.
Even during the worst parts of 2008, positive surprises far outweighed the negative. A rare spike in negative earnings surprises that year reversed a decade-long trend that saw less than 20% of S&P 500 companies miss their estimates in most quarters.
Positive earnings surprises become mostly meaningless when the numbers are gamed so frequently. Instead, we look at forward estimates and earnings misses, both of which can undo years of growth if they underwhelm, and both of which usually offer better information on a company's present and future prospects. Netflix (Nasdaq: NFLX ) didn't miss estimates when its stock tanked last year; poor guidance led to the lion's share of its woes. Its latest smackdown came despite another bottom-line beat, with poor guidance and weak sales again scaring investors away.
What it means for you
When one company whiffs, it might not mean much, but when many do, it creates an unmistakable trend. Just how bad has it gotten? Let's take a look at second-quarter results through the month of July for both this year and 2008:
|Companies Beating Expectations||644 (58.2%)||265 (58%)|
|Companies Missing Expectations||348 (31.5%)||138 (30.2%)|
|Companies Meeting Expectations||114 (10.3%)||54 (11.8%)|
Source: Yahoo! Finance, author's calculations.*Data through July 23.
It's certainly possible that a torrent of data through the rest of July will change the numbers somewhat, but thus far, 2012's second quarter looks almost exactly like 2008's, at least from the earnings-surprise standpoint. Corporate profits were at all-time highs heading into this year, but more recent employment data seem to show a recovery that's losing steam:
Source: St. Louis Federal Reserve.
Global companies have thus far done a great job maximizing their profits in the face of many headwinds, but it's not just the Eurocession that might make this a terrible quarter. A devastating drought has already taken a toll on the food industry, and is likely to squeeze margins for months to come.
McDonald's (NYSE: MCD ) , Yum! Brands, and Chipotle (NYSE: CMG ) all disappointed investors with their second-quarter reports, and the economic impact could spread beyond the usual culprits. Power plants that rely on water for cooling and retailers offering home-improvement lawn and garden implements could also be at risk -- and if the power goes out, most people quickly find themselves with little to do besides hoard ice.
What you can do about it
In times like these, it's not enough to look at a major one-day or one-week decline as a potential buying opportunity. Europe's problems aren't going anywhere. Drought conditions can leave deep wounds across many industries, and food shortages could crimp global growth well into 2013.
This spate of earnings whiffs may be the tip of the iceberg, as it was in 2008, or it could simply herald short-term weakness that'll soon be behind us. Don't jump into any new investment without carefully considering both the stock-specific headwinds and the global trends that could act on it in long-range ways.
The best defense, as it was during the last recession, will be dividend stalwarts with business models resistant to both consumer belt-tightening and sudden input-cost shocks. The Motley Fool's put together a list of nine rock-solid dividend stocks that fit the bill, and they're all available in our free report. Click here to get the free information you need.
Also, to understand more about Apple's disappointing quarter, read about the company in our new premium research report on Apple. In it, our top technology analyst walks through the key aspects of the Apple story, including both opportunities and risks facing the company.