Halloween is a key date in the calendar for those who believe there are seasonal trends in the stock market. It’s the moment when those that had “sold in May and gone away” return for six months of supposedly better performance. Yet, investors hiding behind the sofa this summer missed an 11% rise on the FTSE 100. From here, however, the outlook for earnings has got a great deal murkier in recent months. To combat this, the views of analysts - if you read them right - could help defend against unwelcome horror stories.
One of the main factors currently spooking investors about future earnings is the decline in the value of sterling since the summer. It’s fraying nerves because no-one really knows what the impact on company profits will be next year.
What we do know is that there have been some high profile profit warnings recently - such as NCC, Keller, Cobham and Travis Perkins. And while these weren’t sterling-related, they’re a reminder of the dramatic price falls that occur when a company disappoints on earnings. In these conditions, earnings forecasts are closely watched - but how are they best used?
Forecasting company performance
To start with, there is a lot of research (which we have written about) that shows that broker forecasts and recommendations should be treated with caution. Investors are rightly wary about the credibility of company research and whether analysts are truly objective. Of all the thousands of stock recommendations made each year, only around 10% ever advise selling stocks. In other words, analysts are at best optimistic and tend to herd together for fear of making wayward forecasts. At worst, some argue that analysts are more worried about staying on the right side of company management than giving an objective opinion.
But despite the concerns, studies show that there are ways of reading between the lines of analyst research. One way of doing that is to look closer at those stocks that are attracting the greatest level of upgraded earnings forecasts. Back in 2006 two researchers called Phillip McKnight and Steven Todd, found that portfolios of shares with recent strong ‘earnings upgrades’ routinely produced strong returns. They found that earnings upgrades actually caused investors to take a ‘wait and see’ approach - and that reluctance eventually caused prices to drift upwards for…
