1 Huge Warning Sign You Need to Notice Now

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.

Surprise!
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:

 

2008

2012*

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.

Fool contributor Alex Planes holds no financial position in any company mentioned here. Add him on Google+ or follow him on Twitter @TMFBiggles for more news and insights.

The Motley Fool owns shares of Netflix, Chipotle, Apple, and McDonald's. Motley Fool newsletter services have recommended buying shares of Chipotle, Netflix, Apple, and McDonald's, as well as creating a bull call spread position in Apple. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


Read/Post Comments (7) | Recommend This Article (24)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 25, 2012, at 12:41 PM, SharpNJ104 wrote:

    Interesting information on the % of misses. I'll have to pay attention to the rest of the earnings reports.

  • Report this Comment On July 25, 2012, at 5:43 PM, pricedright wrote:

    What does the author mean by "poor guidance"?

  • Report this Comment On July 25, 2012, at 6:03 PM, TMFBiggles wrote:

    @ pricedright -

    "Poor guidance" here means that the company offered an unexpectedly bad estimate for future quarters or for the full year, either significantly undercutting its earlier predictions, the Street's expectations, or both.

    It's the part of the release where it says "We expect full-year earnings per share to be XX instead of YY now," or something similar.

    Hope that explained it.

  • Report this Comment On July 25, 2012, at 8:36 PM, aptosjoe wrote:

    I thought every one was already aware that the momentum for earnings growth was running out of steam. I recall reading this in an MF article last year.

  • Report this Comment On July 25, 2012, at 10:39 PM, TMFBiggles wrote:

    @ aptosjoe -

    This isn't about earnings growth (which has not slowed in the most recent data I had available), but about earnings expectations for public companies. Earnings growth can't continue forever, but analysts (including investor relations staff within public companies) should be able to adjust their forward estimates to accommodate any downturns.

    It's the inability to anticipate a decline that's notable now, more than a decline per se.

    - Alex

  • Report this Comment On July 25, 2012, at 10:54 PM, ravens9111 wrote:

    Earnings surprises right now are mostly due to the fact that most analyst expectations have already been lowered dramatically. When the bar is set so low, it is a lot easier to beat. When the bar is raised high, and you beat, then that is more impressive. Earnings season this quarter may have more "surprises", but the truth is that revenue misses has become harder to beat. If companies can't generate more revenue, where are they going to get earnings growth when cost cutting can only do so much now? Companies have found ways to cut costs, but revenue growth is not there. That should be very worrisome. Also, let's not forget that many of these companies derive a lot of revenue from Europe and Asia. A stronger dollar will make it even harder to increase revenue when goods are more expensive overseas, not to mention the translation exposure of foreign exchange rates.

  • Report this Comment On July 27, 2012, at 3:28 PM, whyaduck1128 wrote:

    You may call them "surprises". I call them "people who know little or nothing doing the estimating". Sometimes the quality of the estimate depends on the quality of the estimator.

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