Doug Kass penned a column for TheStreet.com on Wednesday titled "The Earnings Season Racket."  Kass argues that the earnings "beat" rate is so high this quarter because of lowered estimates, and that "companies almost always beat earnings forecasts even during rough economic periods."  Below is a portion of his column:

While it has been widely advertised by chest-thumping bulls in the media that at least two-thirds of the companies that have reported third-quarter earnings have beaten forecasts, there was less than meets the eye to third-quarter profits as in many cases the "beats" were on lowered estimates.

What is often being ignored is how orchestrated earnings season has become, not only that the beats are from lowered and depressed guidance but that, in many cases, there have been high-profile forward-quarter guide downs.

The reality is that companies almost always beat consensus earnings forecasts, even during rough economic periods. Investor relations departments and Wall Street analysts are very good at getting numbers down to the right level before reports are released. As a result, the actual results vis-a-vis expectations or consensus do not vary materially from historical experiences, in good times and even in bad times.

The argument that earnings are beating estimates simply because estimates had gotten so low has been one that bears have been using this entire bull market.  In reality, however, estimates have increased significantly in recent months.  Back in October 2008, net earnings revisions (% of increases to decreases in revisions) had tanked to multi-year lows.  But it also bottomed that month and then traded sideways until February 2009.  Just prior to the market lows in March, however, the net earnings revisions ratio began to tick higher.  Earlier this summer, the earnings revisions ratio actually moved into positive territory, which meant anaysts were raising estimates for companies more than they were lowering them.  Leading up to this earnings season, the percentage of companies raising estimates hit a two-year high.  Upside estimates have been outpacing downside estimates for a few months now, and companies have still been able to beat estimates at a high rate, which we believe is a major reason for the rise in the overall market.

Kass' argument that companies almost always beat consensus forecasts even during tough times also needs some explaining.  Over the last decade, 62% of the tens of thousands of earnings releases were better than analyst expectations.  But the beat rate has had pretty big swings from a quarter to quarter basis that has ranged from 50% to nearly 75%.  While the majority of stocks are going to beat in any given quarter, some quarters are significantly better than others. 

Below is a chart showing the quarterly earnings "beat" rate going back to 1998.  As shown, the beat rate was strong during the last couple quarters of 1999, and it peaked in Q1 2000 just as the market peaked.  From that point until Q3 '01, the "beat" rate remained below 60% and trended lower.  From Q4 '01 (which would have been the numbers released in January/February 2002) to Q1 '04, the beat rate progressively increased each quarter. This coincided with a big increase in the stock market as well.  The last peak that we saw in the quarterly "beat" rate came in Q3 '06 when 73% of companies beat estimates.  The number remained above 60% through Q3 '07, but it had started its drift lower.  This downtrend continued all the way until Q4 '08 (numbers released in January/February '09) when the "beat" rate hit a low of 55%. 

The earnings season in April and May of this year was the first increase in "beat" rates since Q1 '07.  In that earnings season, the "beat" rate came in at 62%, which was surprisingly positive at the time, and one reason why the market did very well during over the spring and summer.  The "beat" rate got even better last earnings season (68%), and we're on pace to have the best "beat" rate since at least '98 this quarter.

To brush off the earnings "beat" rate because earnings "almost always beat estimates" is not a good idea.  We believe it's important to follow the trend in quarterly "beat" rates, as a trend higher is indicative of a strong market, while a trend lower is a negative sign.  Surprisingly better than expected earnings reports have been a big part of the current bull market. 

If Kass wants a bearish argument, he could actually make the case that the high "beat" rate this quarter will most likely be the peak in the cycle since it is so high.  It's going to be tough for the next earnings season to have a stronger "beat" rate than this quarter, which could mean the start of a downtrend.  But nowhere in Kass' column does he mention this.

In conclusion, the data shows that companies have been beating raised estimates and not lowered ones during this bull market, and the direction of quarterly "beat" rates is a trend that investors should definitely follow.

Subscribe to Bespoke Premium to receive more in-depth analysis from Bespoke.