Bulls versus Bears

Sure, the price of an equity will move after an earnings release. The downside move on a miss is usually larger than the upward move on a surprise, and there is a good reason for that. Earnings estimates by analysts as well as earnings guidance by companies are almost every time way below what they actually think or even know it should or will be. Keep in mind that the only party which will not be able to make a profit on a decline in the price of an equity is the company itself and therefore most companies will provide a very conservative estimate as far as their earnings are concerned, while other don't guide at all in order to avoid disappointment.

Before we go in a bit more detail as of why companies usually beat estimates we will take one step back and look at analysts. Most analysts are not sophisticated professionals when it comes to equity markets. They are called professionals as they earn money with what they do, they execute their profession, but by no means are they sophisticated. Compare it to a corn farmer who will be paid to be a heart surgeon. The 'corn-farmer-turned-heart-surgeon' will earn money from being a heart-surgeon and can therefore be labeled as a professional, but at the same time the corn farmer will very likely kill each patient as no knowledge and sophistication on the part of the corn farmer is present in regards to heart surgery.

1. Companies start out with ridiculous low guidance in order to make it very simple to beat their own guidance and to cause analysts to start out with very low expectations. In isolated cases guidance is so low that as long as the company will remain in business they have beat expectations.

2. Companies need to beat their own guidance as well as analysts' estimates as companies are the only party which is not bale to profit from a decline in the price of its equity. There are executive bonuses tied directly to the performance of that share price which is another reason PR departments will use every chance to provide a boost to the share price.

3. The price of an equity will move the second earnings are released. The move to the downside on a miss is far greater, in most cases, that the move to the upside on a beat. It is not very hard to initiate a sell-off, since bulls lack sophistication and follow the herd. Convince one bull that the bull was 'full of shit' and the herd will follow, sell-off all the way until the bears start to look for bargains. The most recent example was March 2009.

4. Most analysts have a bullish bias and are tied to the company in one form or another. Since 99.8% of all market participants fall into the Dumb Money Camp, with mutual funds and retail investors as prime examples, they tie their performance, or rather lack thereof, to the state of the equity markets. Most analysts are employed by Dumb Money outlets, such as mutual funds, and portfolio managers, or rather portfolio mismanagers, follow their recommendations which is another reason an analysts is better off to lowball estimates in order for the company to be able to beat expectations and provide a short boost to the price of the equity.

5. Most analysts like to be on good terms with management as they rely on information management provides. Some analysts cling to the hope that they may get timely information a bit sooner than others in order to be able to come up with low estimates which the company will beat. It is a 'win-win' situation for the company and the analysts, at least they like to think so and the markets prove them wrong each time.

The above are just five reasons as of why companies usually beat analysts' estimates, regardless of the state of the economy. Analysts are not sophisticated and do not understand equity markets. They take an uneducated guess at best when they evaluate a company and come up with guidance. It simply does not matter what analysts have to say. Those who follow them around and act on their recommendations should clearly understand by now why their portfolio punishes them year in, year out. Those who are still clueless, load up on a few more mutual funds...

One reason is that you have totally subscribed to the illusion they have created and fell victim to themselves. The illusion that analysts have the knowledge and insight required to make an intelligent call. They have created the illusion that they are smarter than the average retail investor and human psychology takes care of the rest. Once an individual or a group of individuals is viewed as smarter than the average they are followed, at least from a bullish perspective.

When a company beats analysts' estimates as well as their own guidance it usually translates in an in-line performance. Keep in mind that the individuals at a company which prepare earnings guidance are those who should know how the company will perform. They are aware of what negotiations they are in, what demand looks like, how big cost-cuts will be and are aware to a great degree of all other factors which will directly impact earnings. They should not be surprised. A company which is surprised about their own performance can be compared to a driver who accelerates a car to 100 miles per hour and than acts surprised that the car accelerated to 100 miles per hours. Ridiculous!

When a company's earnings are in-line with estimates it usually translates into a disappointment and really means that the company has missed or underperformed. When a company is in-line with the lowball figure, problems are in the pipeline.

When a company provides an outright miss of analysts' estimates it reflects severe problems, which is why the share price drops rather significantly. Missed estimates is a clear indicator to even the Dumb Money camp that all their 'manipulation of estimates' was not enough to allow the company to beat estimates. Now everyone knows that there are severe problems within the company and it is evident that the reason for the long position is clearly no longer present.

The answer is simple. Portfolio mismanagers have to go along with analysts' recommendations and each party involved will have to go along with their illusion, which is why the majority lost sight of reality and believes the illusion they have create is now the real world, and they act surprised while at the same time use that as yet another sales pitch to pump the price of an equity higher beyond reason or sense. That also explains why the drop after a miss is far greater than the rise after a beat.