“Tough crowd.”

That’s what a stand-up comedian often mutters into the mic, when an audience is difficult to please.

This earnings season, you could call Wall Street a tough crowd. The combination of rising interest rates, a lingering pandemic, and hotter inflation is compelling a more critical view of corporate earnings.

Stocks snapped a three-day losing streak Tuesday, with U.S., European, and Asian equities closing sharply higher. Easing tensions in Ukraine sparked a relief rally. Major global indices were broadly higher in early trading Wednesday.

The transnational rally reminds us that geopolitical tensions are ephemeral. The real focus should be on hard data, especially corporate earnings. On the earnings front, we’re getting mixed signals.

According to research firm FactSet, 77% of S&P 500 companies to date have reported actual fourth-quarter 2021 earnings growth above the mean estimate. In aggregate, companies are reporting Q4 earnings that are 8.6% above estimates, led by the consumer discretionary sector (see chart).

However, the market is rewarding positive earnings surprises less than average and punishing negative surprises more than average. Let’s look under the hood and see why.

Less of a bounce…

S&P 500 companies that have reported positive Q4 earnings surprises have seen an average price increase of +0.5% two days before the earnings release through two days after the earnings release. This percentage increase is smaller than the five-year average price increase of +0.8% during this same window for companies reporting positive earnings surprises.

Companies that have reported negative earnings surprises for Q4 have seen an average price decrease of -3.0% two days before the earnings release through two days after the earnings. This percentage decrease is larger than the five-year average price decrease of -2.3% during this same window for companies reporting negative earnings surprises.

During the past two years, as investors enjoyed abundant stock gains, they gave companies a wide berth when reporting earnings. As long as revenue and earnings per share met expectations and guidance fell within an acceptable range, the stock moved up. But lately a post-earnings bump is not a guaranteed event, as investors get more skeptical when reviewing numbers.

The line of thinking regarding whether a stock rises or not after an earnings beat has gotten more complicated. Federal Reserve tightening and the low comparative baselines of the pandemic era have made the quality of the beat increasingly important.

Rising interest rates play an especially big role in regard to guidance. The value of any asset is its future cash flows discounted at the existing interest rate. When interest rates are rising, future earnings are worth less.

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Teasing out the details of a high or low-quality earnings beat can be complicated. However, a simple rule of thumb is whether the better-than-expected results were above or below the operating income line of the income statement.

Numbers above the line include revenue, cost of goods, product margins, and operating expenses. Higher than expected revenue, better margins, and/or lower expenses will produce a high-quality earnings beat.

Numbers below the line include the number of shares outstanding, the tax rate, interest expense, and the litany of “one-time” charges or income that fall below the operating income line.

Did the company beat earnings due to a lower-than-expected share count, a lower tax rate, or special one-time events? Any of these benefits might be considered low-quality during a slumping market.

Below the line boosts are not untoward or adverse but are not typically repeatable events. It is unlikely a company can continue lowering its share count or tax rate indefinitely. However, above the line metrics like sales growth, profit margins, and expense control all provide companies with a roadmap for higher earnings in the future.

As 2022 unfolds and risks increase, investors are beginning to realize that companies will have to deliver terrific improvements to operating earnings to jump start growth rates. In these murky times, investors are wise to look for trading techniques that provide reliable results. My colleague Jim Fink provides just that.

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John Persinos is the editorial director of Investing Daily.

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