Rate cut offers pardon for earnings confessions

TWO of the most powerful drivers of stock prices have locked horns as we head into the dreaded month of May. The positive impact of lower official interest rates is facing off against a slew of earnings downgrades from companies across a range of sectors. A series of rate reductions could act as the long awaited kick-start for the non-mining sector, while earnings downgrade season is the here and now. Changes in either one inflate or puncture a stock price.

TWO of the most powerful drivers of stock prices have locked horns as we head into the dreaded month of May. The positive impact of lower official interest rates is facing off against a slew of earnings downgrades from companies across a range of sectors. A series of rate reductions could act as the long awaited kick-start for the non-mining sector, while earnings downgrade season is the here and now. Changes in either one inflate or puncture a stock price.

With last week's timid consumer price index number the market is expecting a 25 basis point cut in official interest rates tomorrow followed by another 25 basis points in June. For economic activity to spark and sharemarket investors to get excited, a third cut would be needed before we farewell 2012. To score a troika though will depend on the economic numbers printed and the impact of the carbon tax post July. Lower interest rates not only jump start economic activity they also force investors to close term deposits and put their money into more productive assets such as equities.

This month Richard Coppleson from Goldman Sachs noted in his widely read daily market report that Australia has experienced four interest rate cutting cycles since 1988. He concluded the 1996 and 2001 down cycles most closely mirrored the current environment. On both of those occasions the market was higher six and 12 months after the first cut in rates. The major beneficiaries from the lower rates were the banking, retail, transport and building materials sector. This is no surprise given these sectors are cyclical in nature and investors are keen to get set ahead of stronger earnings in the months ahead. Media is a later cyclical beneficiary.

May is also the main month for earnings downgrades on the Australian sharemarket. According to research by Goldman Sachs, since 2000 14 per cent of all earnings revisions happen in May, compared with the average of 8.3 per cent. To compound matters June is the third worst month of the year with 11 per cent of earnings downgrades being announced.

Professional investors and analysts have tagged the dreaded two-month period as the "earnings confession season". Unfortunately, unlike a religious confessional, a company divulging bad earnings news does not make anyone feel better from cleansing the soul.

The reason behind this seasonality in earnings forecasts seems fairly straightforward. Companies experiencing operational difficulties try and catch up during the months of March and April, but, under the continuous disclosure rules set down by the ASX, they eventually succumb and come clean before the end of the financial year. Management teams and their boards live in hope that activity picks up in time to make their forecasts. As German philosopher Friedrich Nietzsche wrote: "Hope is the worst of all evils because it prolongs man's torment."

Earnings are crucial to the performance of a share price. If a company announces one or more earnings upgrades its share price will generally rise while a company that downgrades one or more times will generally see its share price decline. 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 the top quartile of stocks in regards to earnings revisions and selling short the stocks in the bottom quartile. This has delivered a gain of around 150 per cent, more than double the overall market for that period.

It would seem that in 2012 the earnings downgrades have started early and possibly the carnage will not be as great this May. Several stocks, including Mirvac Group, Seven West Media, Stockland, QR National, Bradken and Boral, have already confessed their earnings forecasts were too high. This trend should continue as analysts wind back earnings with the domestic and Chinese economies decelerating. The companies that would seem most at risk are those that were behind at the December half but are hoping for a better second half. Among these companies are Salmat, Brambles and OneSteel.

Given stock prices tend to fall on an earnings downgrade, many investors think it is a good time to buy. Research conducted by Macquarie Equities some years ago debunked this theory. A company that downgrades its earnings has a 35 per cent chance of offending investors for a second time within a six-month period. As for the other 65 per cent, there is very little chance of an offsetting upgrade in earnings.

Interestingly, 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 following six months. This seems contrary to logic, but indicates it is a big shock to the market place and expectations about the company have been pulped.

This leaves investors with a major 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, then investors should have an eye to a better 2013 rather than the pain of lower earnings today. As they say in the US "never fight the Fed".

Ex-fund manager Matthew Kidman is a director of WAM Capital.

A company divulging bad earnings news does not make anyone feel better.

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