Strategies: Rosy Earnings Forecasts, at Least at First

IS the glass half full or half empty? For several thousand analysts who make a living assessing the value of publicly traded stocks, the answer depends on which week it happens to be.

That’s what a study of the Standard & Poor’s 500 earnings cycle by Thomson Reuters/I/B/E/S shows.

The distant future sometimes looks better than the mundane day-to-day of the moment. For stock analysts who crunch numbers to come up with earnings estimates for individual companies, the far horizon is often just one year down the road. And the numbers show that when analysts estimate quarterly earnings a year in advance, they tend to be unrealistically optimistic about the prospects of companies they cover, according to Greg Harrison, the senior research analyst at Thomson Reuters who did the study.

Mr. Harrison’s day job involves compiling consensus earnings estimates for the overall stock market, figures he derives from the collective appraisals published by thousands of individual analysts. Does the market expect earnings for the S.& P. 500-stock index to rise or fall, and by how much? Have companies met expectations for the quarter, or will they disappoint the market? Some of the answers come from the data he gathers each week.

But while doing his work, he noticed a consistent pattern in the numbers, which he describes in a fascinating study of earnings since 2008, titled “Estimates Too High, Low? Check the Calendar.”

Except for several quarters in the Great Recession, he found, early earnings estimates are generally rosy, and become predictably and progressively gloomier as time goes on. As analysts revise estimates downward, it becomes easier for companies to beat the market consensus, creating what Wall Street calls a “positive earnings surprise” roughly two-thirds of the time.

Positive surprises, of course, are good for share prices. Negative surprises are not. And by being optimistic about the long-term future, and relatively pessimistic about immediate results, the quarterly cycle of stock market earnings estimates has the effect of bolstering the market.

Analysts, of course, are encouraged in this practice by corporate executives who routinely issue warnings — “guidance,” in Wall Street parlance — that their companies won’t really meet the analysts’ lofty targets. The analysts respond by lowering their targets.

Typically, Mr. Harrison finds, analysts are most accurate — neither too optimistic nor too pessimistic — about seven weeks before companies actually release earnings.

“That’s when analysts’ estimates and the eventual, real numbers meet,” Mr. Harrison said. But the analysts don’t leave well enough alone. Instead, they keep cutting their forecasts and end up being gloomier than reality warrants. “By the time earnings season actually ends,” he says, “it turns out that the analysts have been too pessimistic — and we end up with a lot of ‘earnings surprises.’ ”

We’re now near the end of the earnings season for the second quarter. Most big companies have already issued their final numbers for the period, and the current pattern fits the overall picture fairly well, Mr. Harrison says.

On July 2, 2012, for example, when he compiled the first market consensus for the second quarter of this year, analysts as a group were projecting great things for stocks one year ahead. They said earnings would grow at the blistering pace of 14.4 percent in the second quarter of 2013.

Reality hasn’t come close to matching that early optimism — but because analysts repeatedly ratcheted their projections downward, earnings reports have been surpassing the relatively pessimistic estimates of recent weeks.

On Friday, with 462 members of the S.& P. 500 reporting, Mr. Harrison found that the actual growth rate so far has been only 4.9 percent. Yet 67 percent of those companies beat the analysts’ estimates, producing positive surprises. How was that possible? Analysts collectively dropped their estimates for the quarter to only 2.9 percent on July 1, when earnings season began. The actual results were much better than that.

The rough pattern held for many major companies. Consider General Motors. On July 2, 2012, analysts covering G.M. estimated that it would have earnings per share of $1.25 in the second quarter of 2013. That July, the estimate of Ryan Brinkman, an analyst at J.P. Morgan, was $1.12. G.M. has “best-in-class leverage to global growth markets, ongoing operational turnaround, and improving product cadence,” he wrote.

G.M. has had problems, however. The company acknowledged that it was doing poorly in Europe. By mid-April, after a report that industrywide sales there had plummeted to a 30-year low, and that G.M.’s Opel brand was lagging, analysts’ estimates fell to 73 cents a share. Mr. Brinkman’s was 72 cents. For all analysts, they stood at 74 cents at the beginning of July and edged up to 75 cents the week of July 12.

But that was still way off the mark. G.M.’s actual earnings, released on July 25, were 84 cents a share. Although earnings declined compared with a year earlier, news coverage generally treated the announcement as a positive surprise.

Mark Bradshaw, an accounting professor at Boston College, says what we are seeing is probably overconfidence by analysts and deft maneuvering by corporate executives, who have leeway in adjusting accounting to improve reported profits and in choosing what information to reveal. “For companies, issuing ‘guidance’ has become an art form,” he said. “The analysts seem to try to do what they can, but they’re often at a loss.”

Aswath Damodaran, a finance professor at New York University, called the earnings season “a Kabuki dance” in which “analysts are trying to forecast; companies are trying on the other side, with accounting choices, to affect those earnings and to lower the forecasts; the companies watch the analysts; the analysts watch the earnings; and it’s all a big game. And it’s a game that the companies generally win.”

Frequent traders scrutinize these rituals, he said, seeking nuance. For them, he said, “it’s not enough now just to beat the earnings forecast. That’s too common. Now, you’ve got to beat the forecast enough — by a big-enough number that it really is a surprise — if you want to stir up the market.”

In his view, most of us would be better off ignoring short-term earnings reports. “None of this matters much to long-term investors,” he said. “It’s the long-term picture that’s important, and that is revealed eventually, even if it isn’t clear now.”

Is the glass half full or half empty? Don’t even try to figure that out during earnings season.

Bond Purchases by Fed Will Continue, at Least for Another Month

As expected, the Fed’s policy-making committee voted to press ahead for now with its campaign to increase job creation. And its statement said nothing about how much longer it would continue to add $85 billion a month to its holdings of mortgage-backed securities and Treasury securities. But the Fed left its economic outlook basically unchanged, suggesting that the central bank still intended to reduce the volume of its purchases later this year.

The statement, issued after a regular two-day meeting of the Federal Open Market Committee, acknowledged the weak pace of growth during the first half of the year, which it described as “modest” rather than “moderate” — the words are synonymous in English but distinct in the Fed’s carefully calibrated lexicon, suggesting an even more lackluster economic performance. But it maintained the Fed’s forecast that “economic growth will pick up from its recent pace” in the coming months, driving job creation.

The statement also repeated language first introduced after the Fed’s previous meeting, in June, that “the committee sees the downside risks to the outlook for the economy and the labor market as having diminished since the fall,” when the Fed began this latest push aimed at increasing the pace of growth.

Analysts said they expected the committee to cut back at its next meeting in mid-September. Dean Maki, chief United States economist at Barclays Capital, said the statement was “on the dovish side” because of its references to slower growth, rising mortgage rates and low inflation. Nonetheless, he added, “We continue to expect the F.O.M.C. to taper the asset purchase program in September, provided that the next two employment reports are reasonably strong.”

The committee had little time to grapple with the implications of the latest economic data. The government announced earlier Wednesday that the economy expanded at an annual rate of 1.7 percent in the second quarter, better than economists had expected but below the pace that Fed officials regard as necessary to create enough jobs to bring down the unemployment rate.

The Fed repeated its stark assessment that “fiscal policy is restraining economic growth.” It also noted that “mortgage rates have risen somewhat,” a new check on the economy that is at least partly of the Fed’s own creation.

The average interest rate on a 30-year fixed-rate mortgage rose to 4.37 percent in July from 3.54 percent in May, according to a survey conducted by Freddie Mac. But that increase is only partly the result of investor uneasiness about the Fed’s plans; it also reflects an improved economic outlook. And that improved outlook, in turn, is mitigating the impact of the rate increases.

David Hall, president of Shore Mortgage in Troy, Mich., said that the higher rates had cut into demand for refinancing, but that demand for mortgages to buy a home remained strong. “People understand the historical context, that these are still really low rates, and coupled with all the news about home values rising, there’s still a lot of excitement about buying,” he said. “That excitement has overshadowed the rate increases a little bit.”

The Fed has also become more concerned about the sluggish pace of inflation. Prices rose at an annual pace of just 0.8 percent in the second quarter, according to the Fed’s preferred measuring stick, a measure of inflation compiled by the Bureau of Economic Analysis — well below the 2 percent annual pace that the Fed considers healthy. Low inflation can cause problems, although Mr. Bernanke recently noted that the reasons were “hard to explain to your uncle.” The primary cause for concern is the risk that prices will begin to fall, which can plunge the economy into a debilitating cycle of deflation as prospective buyers wait for prices to fall even further.

James Bullard, president of the Federal Reserve Bank of St. Louis, chided his fellow officials for underplaying this risk at the committee’s June meeting. This time the Fed noted the risk in the statement but maintained its official view that the pace of price increases was likely to rise.

DealBook: UBS Expected to Pay At Least $1 Billion to Settle Libor Case

Michael Buholzer/ReutersAxel Weber, the chairman of UBS, which is in final negotiations with American, British and Swiss authorities.

10:00 p.m. | Updated

Federal prosecutors are close to securing a guilty plea from a UBS subsidiary at the center of a global investigation into interest rate manipulation, the first big bank to agree to criminal charges in more than a decade.

UBS is in final negotiations with American, British and Swiss authorities to settle accusations that its employees reported false rates, a deal in which the bank’s Japanese unit is expected to plead guilty to a criminal charge, according to people briefed on the matter who spoke of private discussions on the condition of anonymity. Along with the rare admission of criminal wrongdoing at the subsidiary, UBS could face about $1 billion in fines and regulatory sanctions, the people said.

The steep penalty, a surprise given the bank’s cooperation in the case, would represent the largest fine to date in the rate-rigging investigation. In June, the British bank Barclays agreed to pay $450 million to settle accusations that it influenced crucial benchmarks.

The settlement with UBS, which is based in Switzerland, could come as soon as Monday, the people briefed on the matter said. These people cautioned that the bank’s board had not yet approved the deal and it could still fall apart.

By pushing for a guilty plea, the Justice Department may be signaling a new aggressive stance.

Authorities have been reluctant to indict big banks, fearful of the potential for job losses and the ripple effect through the broader economy. If a bank pleads guilty to a crime, the case can be tantamount to a death sentence because the institution may lose its charter to operate.

With UBS, federal prosecutors are trying to strike a balance. By levying a charge against the subsidiary, authorities send a powerful message, but stop far short of putting the company out of business.

Prosecutors decided against indicting HSBC over money laundering, concerned over the repercussions to the financial system. Instead, HSBC, the British bank, agreed on Monday to pay a record $1.9 billion in penalties.

On Thursday, Senator Charles E. Grassley of Iowa, the top Republican on the Senate Judiciary Committee, sent a letter to Eric H. Holder Jr., the attorney general, criticizing the Justice Department for an “inexplicable unwillingness to prosecute and convict those responsible for aiding and abetting drug lords and terrorists,” referring in part to the HSBC case. Mr. Grassley called the fine “hardly even a slap on the wrist,” given HSBC’s profit.

But the UBS case offers authorities a long-awaited moment to criminally punish a big bank. While the public is still simmering over the lack of prosecutions stemming from the financial crisis, the actions against UBS could help damp concerns that the world’s largest and most interconnected banks are too big to indict.

The Justice Department’s criminal division, which arranged the guilty plea with the Japanese subsidiary, could also strike a nonprosecution agreement with the parent company, the people briefed on the matter said. The deal will force UBS to continue cooperating with the wider rate manipulation case.

In a statement, a UBS spokeswoman said the bank continued “to work closely with various regulatory authorities to resolve issues relating to the setting of certain global benchmark interest rates. As we are in active discussions with these authorities, we cannot comment further.” The authorities leading the case — the Justice Department, the Commodity Futures Trading Commission, the Financial Services Authority of Britain and the Swiss Financial Market Supervisory Authority — declined to comment.

As the UBS investigation comes to a close, global authorities are fast-tracking several civil and criminal cases in connection to the manipulation of important benchmarks, including the London interbank offered rate, or Libor. Regulators and prosecutors have uncovered evidence that points to a systemic problem with the rate-setting process, which underpins trillions of dollars of financial products like mortgages, student loans and credit cards.

Authorities contend that some bank employees reported false rates to squeeze out extra trading profits and deflect concerns about their health during the financial crisis.

The fallout from the Libor case could be significant. The Royal Bank of Scotland has indicated that it could announce penalties before its next earnings release in a couple of months. Deutsche Bank also has set aside money to cover potential fines. In all, the investigation has ensnared more than a dozen big banks.

The push for criminal charges at UBS caught the bank off guard.

After settling a tax evasion case in 2009, the bank was eager to cooperate with authorities and gain leniency in the Libor case. UBS, for example, reached a conditional immunity deal with the antitrust arm of the Justice Department, which was supposed to protect the bank from criminal prosecution under certain conditions. But the deal did not extend to the Justice Department’s criminal division, giving authorities some leeway to take action.

With its reputation and profits on the line, the bank moved to dissuade the criminal division from pursuing charges. Bank officials have been meeting with authorities in Washington in a last-ditch effort to influence the outcome, according to the people briefed on the matter.

Eventually, the bank agreed to the broad contours of a settlement that included a guilty plea by the Japanese subsidiary. The bank is still negotiating the final elements of the deal.

Prosecutors are also expected to charge a former UBS trader who featured prominently in the investigation. On Tuesday, Britain’s Serious Fraud Office arrested three men in connection with the Libor case, including Thomas Hayes, a 33-year-old former trader at UBS and Citigroup, according to people with knowledge of the matter. The three men, which also included two people who worked at the British brokerage firm R P Martin, were released on bail the same day.

A lawyer for Mr. Hayes could not be located.

Mr. Hayes is expected to be a central figure in the case against UBS. The UBS settlement is likely to include accusations that Mr. Hayes and other employees colluded with traders at other banks to influence the direction of interest rates, as part of a broader scheme to increase their profits. Some UBS traders have been suspended or fired over the matter.

Mr. Hayes built his reputation as an interest rates trader at UBS. He worked at the Tokyo office of UBS from about 2006 to 2009 before departing for Citigroup. Citigroup fired Mr. Hayes the next year, for approaching a trading desk about influencing the yen-denominated Libor rates, and the bank reported his actions to regulators.

The role of Japanese operations came to the forefront last December when the country’s regulator sanctioned both UBS and Citigroup. Local regulators discovered that traders at the banks had tried to manipulate the Tokyo interbank offered rate, or Tibor, a main benchmark for borrowing in Japan.

The efforts to rig the rate were “unjust and malicious, and could undermine the fairness of the markets,” the Securities and Exchange Surveillance Commission of Japan said in a statement when recommending the nonfinancial penalties against UBS.

UBS has a big presence in Japan. The bank has more than 1,100 employees in the country, spread across its major business lines.

The guilty plea could have collateral consequences for the unit. For one, the guilty plea delivers a painful blow to its reputation, securities experts say. Depending on the details of the case, the group could also be subjected to an independent monitor and face some limitations on its business.

Charlie Savage and Hiroko Tabuchi contributed reporting.