This Trick Could Haunt Your Portfolio Forever

Judging from the way that companies are celebrating the earnings season, you'd think that the economy was back to firing on all cylinders. Yet in reality, the only thing that many companies are doing is beating analyst estimates that already reflected the huge contraction in the economy -- and if you're a long-term investor, you shouldn't necessarily jump for joy.

Jumping a three-inch hurdle
The disparity between beating estimates and showing real earnings growth is especially clear in this quarter's results. According to Bloomberg, over 85% of the companies that reported their earnings last week beat analyst estimates. Yet on average, the companies saw their earnings shrink by 19% from last year's levels, marking two full years of earnings declines. Those figures are roughly in line with how well the entire earnings season has gone so far. Here are some examples:

Source: AOL Money. *Novellus earned a $0.02 profit in the year-ago quarter.

Sure, it's good news to see that companies appear to be seeing their financial results hit bottom, at least for now. Although many companies' earnings still lag far below their levels of a year or two ago, reversing what had almost become a freefall earlier this year is a necessary first step toward recovering their former glory.

Already baked in?
The problem, though, is that stock prices have already risen substantially from their worst levels and therefore have already priced in the assumption that these earnings reversals would happen sooner rather than later. With the S&P 500 standing more than 50% higher than it did back in March, you'd think that investors would want something more substantial than just beating marked-down estimates by a few cents.

Yet although stocks haven't continued to rise at the pace they had a few months ago, they're certainly not indicating much displeasure about recent earnings reports. The S&P broke the 1100 level briefly last week, and although Dow 10,000 hasn't put a firm floor under the market just yet, neither has the stock market shown any signs of the correction that many have expected to see for a long time.

The better choice
Quarterly financial results give investors important information about how a business is doing. But while most people may be satisfied with headline earnings numbers that beat short-term estimates, the better way to analyze quarterly financials is with a view toward longer-term results.

One great way to filter out some of the short-term noise from a stock's results is by making cyclical adjustments to various measures of that stock's financial health. For instance, when earnings are particularly depressed during a recession, P/E ratios don't work the way they normally do. However, if you go back 10 years to get a company's average inflation-adjusted earnings throughout the period, then it's much easier to put the company's current performance into a longer-term perspective.

In addition, because the year-over-year comparisons are so simple, you can anticipate the superficial response that many investors will have toward them. For instance, since the recession has pushed earnings down over the past two years, it'll be much easier going forward to beat prior-year results. Yet investors focused on the long run need to realize that even if some companies show big earnings growth, it may nevertheless not get them anywhere near their high-water marks back in 2006 or 2007. Similarly, new 52-week highs for stocks may not mean much now, since they only take into account prices after last year's market meltdown was well underway.

Don't get tricked
It's always nice to see good news for the stocks you own. When it comes to earnings results, however, be sure to take a closer look. What most investors see as great news may in reality be much less of a treat than you think.

If you want real growth for your stocks, there's only one way to get it. Tim Hanson knows the secret, and he's telling all right here.