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Playing The Earnings Game



If corporate profits are so weak, why are stock prices so high? Good question. A BUSINESS WEEK survey of 900 companies shows that third-quarter profits declined by an average of 4% from a year earlier, the worst showing since the recession of 1991. Yet the Dow Jones industrial average is up nearly 1000 points in a month and is close to 9000. Sure, the Fed has cut rates twice, and there's plenty of liquidity sloshing around. But aren't real profits supposed to support lofty prices?

Well, no; not really. These days, Wall Street is gaming the quarterly-profits announcement cycle. Beating estimated earnings, not real profits, is the driving force in the market. Corporate "IR" (investor-relations) specialists work through analysts to manage expectations of upcoming earnings. Lower those estimates and then beat them by 10% or so, and bingo! Your stock goes up. Do it quarter after quarter, and you get a rep for delivering to shareholders--even if your stock price is not keeping up with the Standard & Poor's 500-stock index or your industry group.

Thanks to the IR people and analysts, in recent years earnings estimates for the S&P 500 in any quarter tend to start out an average 5% to 8% higher than where the earnings end up. The Street knows this and allows for analysts to whittle down the numbers as the quarter proceeds.

Corporate IR folks then begin talking to the analysts who cover their company, lowering earnings estimates. They have even invented something called "whisper numbers" that they pass on to analysts (not the investing public) just days before release of the real profits statement. This strategy makes analysts eager participants in the game of managing estimates in order to beat them. In July, for example, analysts were forecasting a 10.2% average increase in operating earnings for the third quarter, according to First Call Corp. Highly optimistic. By Oct. 12, the start of the reporting season, analysts had lowered expectations to -3.2%. When the real numbers started coming in, they were 1% above the revised, but severely lowered, expectations. Since companies are beating the final estimates, many stock prices are up.

This gaming of earnings estimates is a way to pump up prices even when the fundamentals for earnings growth are weakening. In the long run, it will antagonize investors. Increasingly, analysts are not to be believed on Wall Street. Soon, the companies themselves won't be either.

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