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Fourth-Quarter Earnings Preview: It’s All About Guidance

It’s official… another earnings reporting season is underway.

Alcoa (AA) kicked off the festivities after the bell on Tuesday. The company put up solid numbers, enough to beat Wall Street analysts’ expectations.

Management also issued an optimistic forecast for the future. The team expects a 7% increase in global aluminum demand this year.

So much for all that global recession talk from the gloom-and-doomers! But let’s not get too carried away about the news. Why?

The short answer is because Alcoa’s earnings report is good for absolutely nothing!

It holds very little to no predictive power for how the rest of the earnings season is going to unfold – and more importantly, how the stock market will respond.

If you want proof (i.e., the long answer), check out this column that I wrote during the last earnings season.

However, while one company’s earnings report can’t predict the future with any reliability, aggregating many companies’ reports does reveal more clues about the future of the stock market.

With that in mind, here are the three collective earnings statistics that you should focus on as the reporting onslaught begins in the weeks ahead…

~ Key Statistic #1: Earnings “Beat Rate”

Stock prices ultimately follow earnings. It’s an undisputed law of the markets. So as long as companies keep producing more profits, share prices are likely to charge higher.

To quickly gauge whether or not the stock market should head higher based on earnings, all we have to do is monitor the earnings “beat rate.” That is, the percentage of companies beating analysts’ profit expectations.

The earnings bar is set extremely low right now. According to FactSet, aggregate fourth-quarter earnings are projected to grow by just 2.4%, year-over-year. Strip out the financial sector, and the growth rate is expected to drop to an almost undetectable 0.2%.

But expectations are just that, expectations. They’re often off the mark.

We want to focus on the actual results in relation to those expectations.

In the last reporting season, 60.1% of companies beat their earnings expectations, which arrested three straight quarters of declining beat rates, according to Bespoke Investment Group.

Bottom line: Any reading above last quarter’s 60.1% should be enough to propel stock prices higher.

~ Key Statistic #2: Revenue “Beat Rate”

Companies can’t cut costs forever to boost their earnings. Eventually, they’re going to have to rely on good old-fashioned sales and/or price increases to boost the bottom line.

Or as Greg Harrison, a research analyst with Thomson Reuters, says: “Revenue gives a better clue as to what the demand is in the economy. You know they can’t really be manipulated as easily as earnings can, so it gives a very straightforward measure of how the business is doing.”

Indeed. And expectations are low heading into this reporting season. Thomson Reuters only expects a 1.9% uptick in revenue.

Let’s not put too much stock in the projections, though. Instead, let’s focus on the actual results.

The good news is, we don’t have to review every single company’s report. All we need to do is track the revenue “beat rate” – the percentage of companies beating analysts’ sales expectations.

In the last earnings season, the revenue beat rate came in at 48.2% – the lowest level since the bull market began.

Bottom line: Any reading north of 50% should provide a catalyst for higher stock prices. A reading north of 60%, which hasn’t happened since the first quarter of 2012, would be extremely bullish, as it would point to increased demand in the face of weak expectations for economic growth.

~ Key Statistic #3: Guidance Spread

The past is the past. What matters most is the future. Especially since the stock market is a forward-looking beast. If more companies issue upbeat forecasts for the future, the stock market is bound to rally on the optimism.

The easy way to track corporate sentiment is by measuring the guidance spread – the difference between the percentage of companies raising guidance and those lowering guidance. A positive spread indicates that more companies are optimistic about the future. And vice versa.

While companies aren’t required to provide future guidance, enough do, which makes it worthwhile to track this statistic.

As a frame of reference, the guidance spread has been negative for the last five quarters. Before that, it was positive for nine quarters in a row.

Bottom line: Any improvement from last quarter’s guidance spread of -5.4% will be a step in the right direction. And any positive reading would pave the way for much higher stock prices ahead.

As always, I’ll provide updates on these three key statistics as the earnings season unfolds. So stay tuned!

Ahead of the tape,

Louis Basenese