Dialling down the Noise

Long term investors should be winners, not losers, from ending quarterly reporting

Traders, Quants and Passive Investors have steadily crowded out most earnings signals for long term investors. Quarterly reports won't be missed, and ironically their ending may help restore the role of fundamental analysis. However, narrative trading will simply go elsewhere and developments in AI, options and meme stocks are already creating a new asset class we might call ‘Equity as Crypto’. As ever, this will present opportunities as well as risks.

In one of the least surprising events in a year of surprises, the Fed cut by 25bp this week. The usual suspects crowded around for ‘greater insights’ from the various members of the Committee (specifically, Chairman Powell and new boy Stephen Miran), but there was really not much to see here. Meanwhile, the macro data continues to confound the Pivot Posse, whose views on an imminent recession continue to be a blend of self-interested market positioning and politics.

What was a surprise however, was Donald Trump’s announcement about ending quarterly earnings announcements. The FT (predictably) thinks this is a bad idea, but we would disagree. As with the circus of the non-farm payrolls, the signal to noise ratio has collapsed and, as Team Trump point out, there is a massive waste of time and money on generating the statistics. There is also a whole raft of bad incentives.

Historically, experienced analysts working on behalf of long-term investors used quarterly updates to adjust and improve long-term forecasts

Historically, when stock analysts at Investment Banks focussed on forecasting upcoming annual earnings numbers and long-term investors rewarded them for accuracy and insight, quarterly updates were somewhat useful, but not compared to experienced analysts having one on one conversations with management. Investors would form a long-term view with the help of specialists analysts and their fund performance would reflect the quality of those insights.

Then people like us spoiled it all by building Quant models

Then strategists (people like us) started aggregating those forecasts and using them for broader market insights and Quants (also us) started building forecasting models for markets, but also for stocks, based around the wisdom of crowds and the concept of earnings momentum. In simple terms, when valuing a stock, if EPS had risen from 6 to 7, the probability of it going to 8 was considerably higher than reversing back to 6 and thus we could weight our probabilities accordingly.

Then the regulators and the noise traders arrived

However, we all know how the story all too frequently ends. The regulators stepped in and insisted that nobody should be able to obtain any privileged information, even if it was a function of their own insightful questioning of management and the quarterly update became an IR exercise. The value of analysts’ estimates collapsed as they huddled around a mean, which was basically what the company ‘guided’ towards.

This meant that the emphasis shifted from Fund Performance to Management Performance as the traders started joining in and the concept of ‘an earnings’' beat’' was born. We reduced the level of event risk - a genuine earnings shock - but increased the short-term price volatility. There was little or no utility for investors in the numbers, but leveraged macro traders, increasingly using options, could 'bet on the beat’.

Instead of having only the monthly non-farm payrolls for their sports-betting type behaviour, the high frequency leveraged traders now had multiple ‘events’ to bet on. As management (particularly in the US) has increasing voted itself ever higher stock awards (see Ratchet, Ratchet and Bingo), the incentives have shifted to focus these reports on maintaining a narrative of ‘stock beats’ to ensure maximum benefit to the management producing the reports. ‘Teaching to the test’ has become the norm.

The net result is that all the time, money and effort to produce quarterly reports goes into the market equivalent of a YouTube short or a TikTok video.

Then came the index trackers

The problem has then been compounded by Passive Investment, or index tracking. Blackrock, Vanguard and State Street dominate the shareholder lists of most major companies, but the manager of (to pick one) the $800bn VOO ETF at Vanguard doesn’t listen to the earnings call on Nvidia, even though it is 8% of their portfolio, and certainly not to any of the 486 companies below number 14 in the list who would be less than 1%.

For context, the smallest stock in the index, with a market capitalisation of 'only’ $5bn would be around 0.009% of the portfolio. It could go completely bust and it wouldn’t even register.

The Index manager doesn’t listen because he doesn’t need to. Nor do the Quants, they simply use the aggregate of everybody else’s data inputs. Nor any more do the active managers. The only people who still really benefit from the quarterly reporting cycle are the noise traders.

..And now, LLMs, AI, same day options and the meme stocks

The traders still do of course, but now it goes beyond the simple numbers. LLM models now scrape the quarterly meetings for key words in the same way as quants scraped them for numbers and the leveraged traders in the ‘Pod Shops’ now try and front run small movements based on other models that look at the same data. Once again, markets have reduced to modelling (and trading) other people’s models rather than the real world.

Quarterly earnings have reduced earnings volatility but increased short term price volatility instead

They have been joined by the army of day-traders equipped with AI models and access to leverage through short term or even zero-day options. Which brings us to the, latest and frankly worrying, evolution in US markets, that is the rise of the Meme stocks.

The ‘Memification’ of US Equities

We discussed these in a recent monthly (A Question of Perception) where we looked at the DORK stocks - named after the four tickers, for Krispy Kreme (DNUT), Opendoor (OPEN), Rocket Technologies (RKT) and Kohls (KSS). All of these companies were sat at all time lows before activists/day traders have elected to ‘do a Gamestop’ on them and squeeze the prices higher. Nothing to do with fundamentals and everything to do with same day options and squeezing shorts.

Even since we mentioned them in early August, the group is up on average by 100%, led by Opendoor, which is up almost 5x in a month. These cracks and inefficiencies are being exploited eagerly now, but will come unstuck at some point - as these things always do. Without participation of institutions and the big index funds, the small and mid cap equity markets have become a different asset class, more like Crypto in fact, where narrative plus technicalities drive short term volatility and prices.

Ending Quarterly reporting will lead to narrative trading shifting elsewhere

This means that this noise has risen even further - as, ironically, has the ability of insiders to exploit it. The fact that Oracle, with a market cap of over $600bn, jumped by almost 40% on the day it actually missed earnings was a fascinating case in point.

The miss was over-ridden by its announcement about what is effectively a $300bn+ investment by Open AI. The initial share price reaction, in our view, was a function of options market makers scrambling to cover in a so-called Gamma-Squeeze, in turn triggering a traditional short squeeze among the leveraged pod traders who were short into the numbers. The short positions were not huge, but the fact that insiders hold over 40% of the shares will have amplified the squeeze.

Oracle’s short squeeze was an example of the new world of AI, Algos and narrative versus earnings

Then the LLM models will likely have kicked in, picking up on the headlines about AI, positive reactions from analysts as well as fast moving momentum algorithms reacting to the previous day’s moves and buying yet more options.

As to the story itself, as usual we would turn to Ed Zitron - who is suitably scathing about the ability of either side to deliver on the great plan. TLDR, Oracle is flagging revenues it expects to generate, by selling data capacity it doesn’t yet have to (mostly) Open AI in return for cash that Open AI doesn’t yet have either. To be honest, the DORK stocks sound more plausible than that.

What we really need

Ideally, long term investors want management aligned through long term incentives not short-dated options. Rebalancing the C-Suite is not easy, but Bi-Annual meeting in which company management are grilled by professional analysts on Corporate strategy would be a start.

The Meme stocks are making small and mid cap equities into almost a separate asset class, like Crypto, driven by narrative, leverage and hype, while the largest stocks are bought and sold as a function of their size, not their fundamentals.

This (should) leave some white space for active investors to build portfolios with a focus on company fundamentals and idiosyncratic risk with a return to old school investment strategies. So long as you are not being judged in comparison to a strategy taking a completely different set of risks, the move to bi annual reporting, far from hindering real investors, should actually return the role of fundamental analysis back towards its proper place.