Why Stocks Are Falling Despite Strong Earnings

By every traditional measure, this earnings season has been a sweeping success for U.S. companies.

With just a few days remaining in first-quarter earnings season, nearly 75% of companies that have reported have “beat” consensus analyst forecasts. The historic average is around 62% earnings beats. The record percentage of earnings beats is 79%, set after the third quarter of 2009.

And most companies haven’t just been eking out their earnings beats. So far, companies have beaten estimates by an average of 7%.

But the “strong” earnings have been of little benefit to U.S. stocks. Since Alcoa (NYSE: AA) unofficially kicked off first-quarter earnings season on April 10, the S&P 500 has actually fallen 0.3%. That’s a far cry from January, when strong fourth-quarter 2011 earnings reports boosted stocks 4.4%.

So what changed?

For one, stocks were overpriced. Riding the momentum from January’s better-than-expected earnings batch, U.S. stocks climbed 12% in the first quarter – the second-best quarterly gain since 2000. Stocks were so beaten down in the second half of 2011 that a bounce-back was inevitable. The problem is they overcompensated.

By early April, right before another earnings season began in earnest, stocks had reached their highest level in nearly four years. That was despite an ongoing sovereign debt crisis in Europe and slow economic progress here in the U.S. Something didn’t add up.

So just as a first-quarter rally seemed inevitable on the heels of such a dramatic down period for the markets in late 2011, a pullback from such extreme highs was long overdue. Sure, an abnormally high number of publicly traded companies beat first-quarter earnings expectations. But so many of those companies’ stocks were already overpriced that they had, in essence, reached their carrying capacity. Earnings beats had already been priced into the stocks.

Which brings me to the other reason why such a “strong” earnings season had so little impact on stocks: because most companies’ earnings weren’t actually that strong. As was the case in the previous earnings season, expectations were so modest that companies didn’t have to do much to blow right by such tempered estimates.

Take the big banks, for instance. Bank of America (NYSE: BAC), Citigroup (NYSE: C), Goldman Sachs (NYSE: GS), JPMorgan Chase (NYSE: JPM), Morgan Stanley (NYSE: MS) and Wells Fargo (NYSE: WFC) all beat first-quarter earnings estimates. And yet every single one of the stocks has declined in the weeks since their earnings were announced.

That’s because while many of the big banks’ earnings were “beats,” they were weak when compared to the same quarter a year ago. Bank of America’s profits were down 68% from the first quarter of 2011. Goldman Sachs’ profits fell 23%. Morgan Stanley reported a loss of $94 million, down from a $968 million profit a year earlier. JPMorgan’s earnings fell 3.1%. Citigroup’s sales declined. Only Wells Fargo actually posted first-quarter earnings that were better than a year ago.

Yet all six of the big banks’ earnings were “beats” since expectations were so low. That was also the case in the previous quarter, but the bank stocks all skyrocketed then since they were so beaten down after a rough 2011.

This time the banks weren’t so fortunate. They were riding the wave of the recent rally, and all six of them entered April at 2012 highs. So this time, earnings “beats” weren’t enough to catapult the stocks any further – not when most of those earnings were lower than they were a year ago.

The banks are a perfect microcosm for what has happened on Wall Street this earnings season. After such a historic start to the year, stocks simply couldn’t maintain such a torrid pace regardless of how many of them beat earnings. While the U.S. economy has come a long way since the recession, the data wasn’t enough to justify the fast start – not when unemployment remains above 8% and our national debt is about to cross the $16 trillion mark.

Earnings season remains an important gauge of how much progress U.S. companies are making. Only this time, that progress had already been factored in.

With so much uncertainty in the global economy, the needle simply couldn’t be moved any higher.

To top