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For The First Time Since The Tech Bubble The Market No Longer Rewards "Beating" Companies

With Q2 earnings season rapidly approaching its end, Bank of America points out a curious observation: stocks that beat earnings expectations are not getting "rewarded" with higher prices. This is the first time this has been observed in 17 years  - the last time the market seemed oblivious to corporate upside was in 2Q 2000... just before the Tech Bubble burst. As BofA warns, "this could be a warning sign that equity market expectations and positioning more than reflect the good results."

Adding to peak valuation concerns, BofA's quant strategist Savita Subramanian also expects full-year EPS growth to decelerate from 8% in 2017 to 5% in 2018, and redundantly adds that "the stock market may not react well to decelerating earnings." That's one way of putting it.

Some more details on this notable "market peak" phenomenon:

Companies which beat on EPS and sales have performed in-line with the market the subsequent one and five days - the first time we've seen no reward for beats since 2000.




Companies which missed on both metrics have underperformed by 3ppt the subsequent one and five days - greater than the historical average underperformance of 2ppt.



Punishment for misses has been greatest in Tech - which is extremely crowded vs. history by active funds. The reward for beats has generally been muted (or nonexistent) across all 11 sectors, but is so far largest in Consumer Discretionary on a one-day basis (1.1ppt) and Real Estate on a five-day basis (1.5ppt). Performance spreads have been muted based on guidance as well (Table 4).


Now as noted above, one possible explanation for this phenomenon of no earnings season upside for the beaters, coupled with substantial downside for everyone else is that it "could be a warning sign that equity market expectations and positioning more than reflect the good results."

Alternatively, as we first discussed last week, another possibility for the bifurcated earnings response is due to the change in market structure itself.

One week ago, BofA's Subramanian again looked at the response of stocks which missed EPS estimates, and found two dramatically different outcomes for stocks with high vs low passive ownership. This is how she describes her findings:

Not only can crowding by active managers suggest risk to stocks, but high-passive ownership can matter, particularly during earnings season. Over the past seven quarters (including the 2Q earnings season so far), stocks with high passive ownership that missed on EPS and sales have underperformed those with low passive ownership by 1.5ppt on average during the following day, and the spread has widened significantly during recent quarters. This increased performance spread may be attributable, in part, to lower "true float" in these stocks, which appears to have driven increased volatility.

The increasingly disproportionate adverse reaction of highly passive-owned stocks is shown in the chart below: it is most evident in Q2 2017 earnings.

BofA's take, which can easily be tested for validation purposes, presents various arbitrage opportunities chief among which is creating a basket of high passive ownership stocks, and betting on sharp declines either through single-name short positions or puts while avoiding low passive ownership names, with expectations of this skewed return profile.

One potential hurdle is that this earnings season - which is now almost over - companies with notable misses have been relatively few, although if this pattern persists, it should provide significant alpha opportunities during the Q3 earnings season, when the overall quality of earnings is expected to decline substantially as the base effect of last year worst quarter will be in the rearview mirror, while the much anticipated surge in energy earnings will have trouble materializing if oil fails to trade solidly in the mid-$50 range, not to mention the risk of either inflation finally creeping higher or the Fed following through with its balance sheet unwind promise.

In any case and perhaps most troubling to the bulls, yet another ghost from a recent market crash has emerged, and whatever the underlying cause, it may haunt traders until the bitter end of the current market cycle which, increasingly more are starting to admit, will be quite dire to most P&Ls.