U.S. Stocks Are Front-Running Third-Quarter Earnings Beats

The cheating season is starting ahead of schedule.

That’s the view of Michael Wilson, Morgan Stanley’s chief U.S. equity strategist, who sees the recent climb in stock prices as an indication that investors are front-running third-quarter results and anticipating that they’ll exceed analysts’ projections.

"The recent push higher in U.S. equities that started on August 21 can be attributed to the realization that earnings will show another solid beat in the third quarter -- similar to what played out in the first two quarters of 2017," Wilson wrote in a note to clients.

Morgan Stanley

Earnings season unofficially kicks off in a month with the release of Alcoa Corp.’s results. Excluding energy-related companies, analysts have a "very modest" outlook for earnings that should be "very achievable," according to the strategist.

The tendency for companies to step over a lowered earnings bar by using conservative and negatively-revised guidance has long been a pet peeve of Andrew Lapthorne, Societe Generale’s global head of quantitative strategy. He’s denounced the practice as a "charade" and previously cautioned clients to avoid being short the market during U.S. reporting seasons.

As such, this nascent trend highlighted by Wilson would be something new, since investors typically haven’t rushed to price in quarterly results that come in well above estimates. With a synchronized economic expansion underway, investors now have more confidence that things will play out as expected -- that is, better than expected -- yet again.

"One explanation is that the low volatility environment we have experienced thus far in 2017 has coincided with a general lack of macro catalysts," Wilson wrote. "Thus, with no significant catalysts present to derail the market’s response to a great quarter, the beat was priced early."

The strategist’s take also offers an explanation for why some of the tech behemoths that were flying high heading into their second-quarter earnings updates unexpectedly slumped despite posting better-than-anticipated bottom-line figures.

Morgan Stanley thinks the S&P 500 Index could rise to 2,550 to 2,575 ahead of the reporting season, which could spark a consolidation phase for the benchmark gauge before an ascendance to its year-end target of 2,700.

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