Wednesday, June 18, 2008
While summer doesn't officially start until Saturday, in many ways it feels as if summer markets are already here. Vol sellers have emerged in equities, fixed income, commodities, and currencies, while conviction and trading interest is reported to fairly light across different products. Closer to home, both traffic and commenting in this space have dropped off over the last few days, though that may say more about a dearth of insight from your author than any underlying market condition.
In any event, yesterday saw a pretty limp reaction to what Macro Man thought would be a touchstone event, namely the release of Goldman Sachs' earnings (more on which below.) Action has been similarly tepid today in Europe, though Asian markets seem to have de-coupled, if only temporarily, overnight. Macro Man retains a short in various European indices, and has seen little to dissuade him that this is the right position to have.
Indeed, perhaps the biggest threat to equity shorts at the moment is that the regulators change the rules of the game. In the UK, for example, the FSA has taken Deutsche Bank to task for proposing a perfectly legitimate trading strategy. Indeed, the UK regulator seems to be more interested in squeezing/screwing shorts than they do about addressing malfeasance on the part of companies, particularly finance firms, which are the very reason that shorts are established to begin with.
Not that misguided regulatory zeal is confined to the Square Mile- far from it. Although the pre-ho Spitzer revolution has cracked down on the worst of the excesses in Wall Street research, the fact remains that analysts are, in aggregate, habitually overoptimistic on the market. The chart below compares the 12 month forward I/B/E/S consensus earnings estimates for the SPX with the actual result; as you can see, over the past 20 years the consensus has overestimated earnings by more than 7%. To put that into context, the actual annual earnings growth over that period has averaged 8.5%.
In fairness, the recent degree of over-estimation has been much less than previous cyclical peaks. But these index-level (over) estimates are only half the story. Because bizarrely, as far as Macro Man can make out, over history a majority of company-level earnings surprises tend to be positive. That is, comfortably more companies beat expectations than fail to beat. (Macro Man has tried and failed to access hard historical data on this phenomenon going back longer than a few quarters; if anyone has the data, by all means pass it along!)
So we're left with a situation where most analysts overestimate earnings on a 12 month forward basis but underestimate earnings on an ongoing quarterly basis. Hmmmm.....something smells kind of rotten there. If this earnings estimate game were truly a fair one, it would be reasonable to expect companies to beat earnings 50% of the time. yet clearly that's not the case.
Consider our friends at Goldman, who currently enjoy universal acclaim as "the smartest guys in the room." That may well be the case, but unless the analysts covering GS are at the other end of the scale, wouldn't we expect them to mark their estimates accordingly? Evidently not. Bloomberg stores quarterly estimates for GS since the beginning of 2006. Since that period, GS have beaten those estimates ten out of ten times. In a "fair game", the cumulative probability of that occurring is less than 0.10%. Indeed, the best model for predicting GS earnings appears to taking the consensus estimate and adding a buck per share.
Judge for yourself whether this is the result of analyst incompetence, or whether GS is gaming the system. It's not like every other IB hits the ball out of the park every quarter. Lehman and Merrill have famously had recent difficulties, and even Morgan Stanley (reporting today) has disappointed expectations three times since the beginning of 2006.
Unfortunately, regulatory zeal apparently doesn't extend to determining just how Goldies (and to be fair, they're hardly alone in this game) manages to beat expectations quarter after quarter. Naked Capitalism highlights potential dodgy goings-on at Lehman with respect to how they managed de-lever in such a crappy market.
That equity markets are gamed isn't exactly new news, and Macro Man doesn't want to come across as a doe-eyed naif who's just discovered that Santa Claus doesn't exist. But just as equities were de-rated in the wake of the late 90's/early Noughties corporate scandals, Macro Man can't help but wonder if a similar de-rating won't occur now, sourced in the twin concerns of inflation and the fact that stocks aren't a fair game.