May is cruellest month, June not much better

Two of the most powerful drivers of stock prices have locked horns as we head into the dreaded month of May. The positive effect of lower official interest rates confronts a slew of earnings downgrades by companies in several sectors.

A series of interest rate cuts could kick-start the non-mining sector the earnings downgrade season is upon us. Changes in either can inflate or puncture a stock's price.

After last week's timid consumer price index number, the stockmarket is expecting a 25 basis point cut in official interest rates tomorrow, followed by another 25 basis points in June.

For economic activity to gather momentum, and sharemarket investors to get excited, a third interest rate cut will be needed before the end of the year. However, a troika will depend on economic data and the impact of the carbon tax, which comes into effect on July 1. Lower interest rates not only stimulate economic activity they compel investors to close their term deposit accounts and put their money into more productive assets, such as equities.

Earlier this month, Goldman Sachs' Richard Coppleson noted in his widely read daily market report that Australia has had four interest rate cutting cycles since 1988. He concluded that the 1996 and 2001 "down" cycles most closely mirrored the present environment.

On both of those occasions, the market was higher six and 12 months after the first cut in rates. The main beneficiaries of the lower rates were the banking, retailing, transport and building materials sector - all cyclical sectors.

May is also the No.1 month for earnings' downgrades. Goldman Sachs' research shows that 14 per cent of all earnings revisions since since 2000 have happened in May, compared to an average of 8.3 per cent each month.

To make matters worse, June is the third worst month of the year, when 11 per cent of earnings downgrades are announced. Professional investors and analysts have tagged the dreaded two-month period as "earnings' confession season".

The reason behind this seasonality in earnings' forecasts seems to be fairly straightforward. Companies with operational difficulties try to catch up in March and April, but under the continuous disclosure rules set down by the ASX, they succumb and come clean before the end of the financial year.

Earnings are crucial to a share price's performance. If a company announces one or more earnings upgrades, its share price will generally rise. A company that downgrades one or more times will generally lose some value on its share price.

Deep value investors may dismiss this assertion as simply momentum investing but empirical evidence suggests it is a profitable approach. Goldman Sachs has tracked the performance of Australian stocks since 1997, by going long on the top quartile of stocks in regard to earnings revisions and selling short the stocks in the bottom quartile. This has delivered a gain of about 150 per cent, more than double the overall market return for that period.

It would seem that this year the earnings' downgrades have begun early and that the carnage will possibly not be as great as usual in May.

Several companies, including Mirvac Group, Seven West Media, Stockland, QR National, Bradken and Boral, have already admitted that their earnings forecasts were too high. This trend should continue as analysts wind back their earnings' estimates because of slowing domestic and Chinese economies. The companies that would seem to be most at risk are those that were behind in the December half but which are hoping that they will sail home in the second half, albeit with wet sails. Among these companies are Salmat, Brambles and OneSteel. Given that stock prices tend to fall on an earnings downgrade, many investors think it is a good time to buy. This theory was debunked some years ago by Macquarie Equities research.

It showed that a company which downgrades its earnings has a 35 per cent chance of offending investors for a second time within six months.

Interestingly, the companies that downgrade and have the most severe decline on the first day will continue to be among the worst performers on the market in the ensuing six months.

This seems contrary to logic, but it indicates that a downgrade is a big shock to the marketplace and that expectations about the company's performance have been pulped.

This leaves investors with a huge conundrum. Do they load up on shares because lower interest rates are positive for future earnings, or do they stay gun shy to avoid a litany of earning shocks?

If the Reserve Bank does deliver three 25 basis point cuts, investors should have an eye to a better 2013 rather than the pain of lower earnings today. As they say in the United States: "Never fight the Fed."

The Sydney Morning Herald accepts no responsibility for stock recommendations. Readers should contact a licensed financial adviser.