All posts for the month September, 2014

A pattern has been firmly established for a few years now, whereby aggregating analysts’ forecasts at the beginning of the year produces an estimate of around 10% annual growth in EPS. With inflation low and economic growth below most estimates of trend, this figure is too much of a stretch for the average company to deliver and analysts then spend the rest of the year trimming their estimates. This is particularly prevalent in the run up to reporting season, when companies attempt to limit the damage to their share price by guiding expectations down, preferably to a level that they can then beat on the day of the numbers.

Across the S&P 500, 63% of stocks have negative EPS momentum over the last month, meaning that analysts have downgraded estimates for the company. This compares to only 50% with negative EPS Momentum over the past three months, showing that sentiment has deteriorated over the past four weeks. The P/E ratio of the downgraded companies is very similar to the median S&P constituent at 16.4x 12 months forward earnings, suggesting that fund managers have responded to earnings downgrades by selling stocks. The S&P 500 index is down a little over 1% over the past four weeks.

Among the hundreds of stocks that have been downgraded in the past month, 27 stand out because the downgrades have coincided with share price rises that are at odds with the rest of the names. One third of this smaller group of shares has had at least 1% cut from estimates, while the average P/E valuation of the stocks has risen to 19.3x, an 18% premium to the index. The table below shows these nine names, with those where earnings downgrades are among the highest in their sector flagged by a red arrow.

image2014-9-30 11-49-28

The table shows the shares that have outperformed despite being downgraded include index heavyweights, such as Bank of America and McDonald’s, where estimates have been cut 8% and 3% respectively over the past four weeks. Technology stocks Yahoo and Motorola are prominent on the list, as is KFC, Pizza Hut and Taco Bell owner Yum! Brands. All but one of these shares has also seen estimates cut over the past three and six months, yet only Motorola and Yum! Brands shares have not risen over this longer period. In the case of Bank of America, where the shares are little changed over the last half year, investors have seemingly disregarded downgrades to estimates of over one fifth. This reflects great faith that the fines and charges dragging down this year’s numbers are only temporary and that the ongoing investigations of the industry either pass by one of the largest banks, or cease altogether.

Over in Europe, where earnings season starts a little later than the US, 60% of the STOXX 600 names have been downgraded in the past month. EPS Momentum has been negative across the index for each of the last three months, in contrast to the US where it has fallen below zero only during September. Thus in Europe 66% of stocks were downgraded over the past three months, suggesting either that the situation is not getting any worse, or that companies have not yet got a handle on Q3 earnings and still have time to guide analysts down. The median P/E valuation of the index is 14.7x, 10% less than for the S&P 500.

35 stocks in Europe stand out for the degree to which a share price rally is at odds with downgrades and 14 of these have seen estimates cut by at least 1% in a month. The list includes one or two of the index bigger beasts, such as GDF Suez the French power supplier, but only one stock in Standard Life where downgrades have been among the largest in its sector.

image2014-9-30 11-50-22

Overall it appears that the impending earnings season in the US has forced analysts to take a more critical view of earnings prospects, with or without the help of company guidance. In a handful of cases investors have chosen to ignore these developments, either dismissing them as one off, or happy that collectively the investment community has discounted all the bad news. The bellwethers of Q3 earnings season in the US may well be the likes of Bank of America, McDonalds, Yum! Brands and Motorola, because these are the stocks where investors are taking the biggest bets against the collective wisdom of the analyst community.


The stocks where option investors expect the biggest change in price action

% difference implied vs. realized volatility
Diamond Offshore Drilling
Jabil Circuit
Republic Services ‘A’
Avon Products
H&R Block
KLA Tencor
Interpublic Group
Western Digital
Citrix Systems
Mead Johnson Nutrition
Constellation Brands ‘A’
Bristol Myers Squibb
Vulcan Materials
Estee Lauder Companies ‘A’
Accenture Class A
First Solar
Becton Dickinson
Iron Mountain
United Rentals


There are many people all too eager to give you their view on stock prices, from professional analysts to bloggers and spammers. But how many of these people have skin in the game and are prepared to back their views with cash. In this respect, nothing can outbid the option market, where professionals and amateurs alike place money down on how a stock will trade over a specific period.

The equity options market can be used to express a view on how much a share price will move, known as volatility, without expressing a view on which direction the stock will move. Of course the investor who buys volatility should know why they expect share prices to move and this will imply a direction of change, but it is the degree of movement that will determine the profit or loss on each trade.

There are two types of volatility; realized, which is what has just happened and implied, which is what is expected to happen. When there is a big difference between the two, and specifically when implied is well ahead of realized, this means that someone out there thinks that change is afoot and that a stock is going to move. Furthermore, they are prepared to commit cash to say that it will.

Right now there are 30 stocks in the S&P 500 where the gap between three month implied and realized volatility is over 50%. Implied volatility captures both the most recent price moves and what is expected to happen, and so we can explain some of these large differences with a quick reference to the news.

Thus Diamond Offshore has been punished for oversupply in the oil market, while Safeway is merging with Albertsons’ and its stock and option markets are in the hands of specialist arbitrageurs.

However, for many of the other names, there is serious money expecting a serious stock price move.

The amount by which the stock is expected with reasonable certainty to have moved in three month’s time is reflected by the level of implied volatility. Dividing this figure by two gives you the percentage gain or loss predicted for the shares.

Beauty and fashion direct sales company Avon Products is expected to be up or down by 15% by Christmas 2014. The run up to the holidays will be an important time for sales at the group and an opportunity to meet or beat the expectations of those analysts paid to predict share prices.

Meanwhile, global technology company EMC is predicted to be 12% either side of its current price of just under $29, while First Solar, an already volatile alternative energy play, should trade in a 42% range, +/- a significant 21%.

For what it is worth, analysts on average have a target price for Avon that is 11% above the current price, and so the options market is expecting more price action than that. The consensus for EMC is 10% upside and for First Solar it is up a paltry 2%.

Someone is going to be badly wrong on that last one. Is your money on it being the guys with the cash riding on the outcome, or those with nothing more to lose than a reputation?