SEC Semi‑Annual Earnings Report Proposal and Fed Opacity Debate

This article examines two significant financial news stories: the SEC's proposal to shift from quarterly to semi-annual earnings reports for US companies and Kevin Warsh's suggestion that the Federal Reserve should become less vocal and more opaque. Both proposals aim to reduce the amount of "news" the market has grown accustomed to, and both face similar arguments for and against them.

The Debate Over Earnings Reports: Quarterly vs. Semi-Annual

The discussion around earnings reports centers on their frequency and content. Historically, the requirement for reporting has evolved:

• 1934: The Securities Exchange Act mandated annual reporting for publicly traded companies.
• 1955: This was modified to require semi-annual reports.
• 1970: The requirement changed to quarterly reports, a practice that has continued for over 50 years.

However, it's important to note that even before mandatory requirements, many companies voluntarily reported quarterly. For instance, an estimated 60% of publicly traded companies in 1931 already did so. Stock exchanges, like the NYSE, also imposed their own quarterly reporting requirements as early as 1939. This suggests that some companies find transparency attractive to investors, regardless of mandates.

International Perspective on Reporting Frequency

The US is somewhat an outlier in its strict adherence to quarterly reporting. Many other countries have experimented with it and often reverted:

• UK: Required quarterly reporting from 2007, withdrew it in 2014, returning to semi-annual.
• EU: Introduced a similar requirement in 2007, removed it in 2013.
• Singapore: Required quarterly reporting in 2003, removed it in 2020.
• Japan: Started quarterly reporting in 2003, reversed it in 2024.

Emerging markets show variation, with India, Brazil, China, and Nigeria generally requiring quarterly reports, while South Africa requires semi-annual. The global trend of reversing quarterly reporting suggests that the trade-offs often work against it in other parts of the world.

The Evolving Content of Earnings Reports

Beyond frequency, the content of earnings reports has dramatically expanded. The number of words in 10Q (quarterly) and 10K (annual) reports has significantly increased:

• 1980s: Reports were minimalist, primarily financial statements and footnotes.
• 2006-2020: The number of words in quarterly reports increased by almost 50%.
• Last 30 years: The number of words in 10K reports has more than quadrupled.

This expansion is attributed to several factors:

• Accounting Rule Changes: Increased mandatory disclosures, some reflecting changes in the business world (e.g., stock-based compensation) and others driven by scandals (to prevent future issues).
• Accountant Relevance: A perceived urge by accountants to add disclosures to maintain relevance, such as fair value accounting.
• Macro Events: Crises like the 2008 banking crisis and the 2020 pandemic lead to more extensive reporting.
• Legal Protection: Companies add more risk sections, partly mandated, but also to protect against lawsuits.
• Increased Guidance: Management provides more forward-looking guidance, a trend that surged in the late 1990s due to legal changes (safe harbor laws) and regulations like Reg FD, though it has receded somewhat.

The "Earnings Game" and Its Impact

The quarterly earnings report has become central to an "earnings game" in financial markets, particularly in the US:

1. Analyst Forecasts: Weeks before reports, analysts forecast earnings per share, revenues, and margins. These estimates are constantly revised based on new information.
2. Market Reaction to Surprises: Historically, stock prices react predictably to earnings surprises: positive surprises lead to price increases, negative surprises to decreases.
3. Earnings Management: Companies actively manage earnings, often using accounting discretion, to beat analyst expectations. Data shows a high percentage of companies consistently beat estimates.
4. "Whispered Earnings": Markets adapt. If a company consistently beats expectations by a certain percentage, that percentage becomes part of the "whispered earnings," meaning the company needs to beat even that higher, unstated expectation to generate a positive surprise.
5. Breakdown of Linkage: This "lunacy" has led to a breakdown in the direct link between earnings surprises and price reactions. Recent data shows little correlation, and the market pricing effect of quarterly earnings is decreasing.

Arguments for and Against Less Frequent Reporting

Advocates for less frequent reporting (e.g., semi-annual) argue:

• Reduces Short-Termism: Quarterly reporting encourages short-term trading and corporate behavior. Less frequent reporting would shift focus to long-term fundamentals and business models.
• Reduces Gaming: It would diminish the "earnings game" and the associated manipulation.

Opponents of less frequent reporting argue:

• Loss of Useful Information: Quarterly reports provide valuable information to markets, and removing them would make prices less informative and more volatile.
• No Shift to Fundamentals: The time saved by analysts and investors wouldn't necessarily be spent on fundamentals but on finding other short-term trading opportunities.
• Increased Insider Trading: Less frequent reporting could create more opportunities for insiders to trade on material, non-public information, making the market seem less fair.

Personal View on Earnings Reports

While acknowledging the utility of quarterly reports for updating evaluations, especially for young growth companies, the material impact of most quarterly reports is often small. The speaker values them as potential catalysts for price adjustments. However, most useful information comes from financial statements, not footnotes or guidance.

The speaker advocates for keeping quarterly reporting but scaling back the magnitude of reports, making them slimmer, more data-focused, and less reliant on "soft data" or opinion.

Regarding "short-termism," the speaker is skeptical of the term, suggesting it's often used to describe market movements contrary to one's own interests. Short-term traders, despite their motivations, provide crucial market liquidity, which benefits all investors by narrowing bid-ask spreads and reducing transaction costs.

The Federal Reserve: Visibility vs. Opacity

The second major topic is the Federal Reserve's role and visibility. For many recent investors, the Fed has been central to market movements, often seen as either a savior or a villain for interest rate changes. This perception, however, is considered unhealthy and a misperception of the Fed's actual power.

Historical Context of the Fed's Role

• Early 1980s (Paul Volcker): The Fed was a powerful but largely background entity. Its actions, like raising rates to combat inflation, had significant economic impact, but public awareness of its internal workings was low.
• Alan Greenspan: Became a celebrity, but more for his market views (e.g., "irrational exuberance") than for the Fed's day-to-day operations. FOMC meetings occurred, but the Fed remained largely in the background.
• Post-2008 Crisis: The Fed's visibility and vocalness dramatically increased. It began providing explicit guidance on its actions and future plans, a trend continued by Bernanke, Yellen, and Powell. This led to an almost constant public fixation on the Fed's every move.

The Fed's Actual Powers and Limitations

The Fed's structure includes 12 districts collecting vast amounts of data, much of which is made public through FRED. The Federal Open Market Committee (FOMC) meets eight times a year to set policy on:

• Open market operations (buying/selling US government securities)
• Size of the Fed balance sheet
• The Fed funds rate
• Policy direction on the economy and inflation

The Fed chair also testifies before Congress semi-annually.

Key limitations of the Fed's power:

• Fed Funds Rate: The only rate the Fed directly sets is the Fed funds rate, an overnight borrowing rate for bank reserves. While it signals the Fed's view on inflation and the economy, and connects to some other rates (e.g., prime rate, some credit card rates), most rates faced by individuals and businesses are not directly tied to it.
• Limited Influence on Market Rates:
  • Short-term rates: While there's a positive correlation between Fed funds rates and short-term market rates (e.g., 3-month Treasury bills), the causation is unclear. Analysis suggests much of the change in short-term rates happens before the Fed changes the Fed funds rate, implying the Fed often follows market movements rather than leading them.
  • Long-term rates: The relationship between Fed funds rates and long-term rates (e.g., 10-year Treasury notes) is even weaker.
• Limited Influence on the Economy: The conventional wisdom that the Fed can significantly move the economy from recession to recovery or vice versa is challenged. Analysis of GDP growth following Fed funds rate changes shows little evidence of the Fed driving economic booms or busts in the subsequent quarter.

The "Wizard of Oz" Analogy

The Fed's power is likened to the "Wizard of Oz": its influence stems more from the perception of its power than from actual, inherent power. This gap between perception and reality is dangerous:

• Policy Makers and Politicians: They may believe the Fed can "fix" economic problems (e.g., lower high interest rates), leading to counterproductive pressures that could exacerbate issues like inflation.
• Investor Laziness: Investors become overly reliant on the Fed, looking to its actions rather than fundamental economic analysis to predict interest rate movements.

The Intrinsic Risk-Free Rate

Historical data on the 10-year T-bond rate, compared to an "intrinsic risk-free rate" (inflation rate + real GDP growth), suggests that market interest rates are primarily driven by underlying economic fundamentals (inflation and real growth), not solely by the Fed. Periods of low interest rates, like the last decade, coincided with low inflation and anemic real growth, not just Fed action.

Recommendations for the Fed

Kevin Warsh's proposal for a less vocal Fed is seen as a positive first step.

• Remove Guidance: Fed guidance is often useless and can be counterproductive by locking the Fed into actions it shouldn't take.
• Embrace Humility: The Fed should openly admit its limitations and acknowledge how frequently it follows markets rather than leads them.
• Allow Markets to Lead: While there will be pushback from investors accustomed to Fed guidance, markets are capable of setting rates and driving future direction, as they did before 2008. This would be beneficial for both markets and the Fed.

Conclusion

The core message is that "more disclosure" isn't inherently better; there's a risk of information overload.

• Earnings Reports: The SEC should preserve quarterly reporting but slim down the reports, focusing on data rather than soft information or opinion. If the SEC opts for semi-annual, it's not ideal but manageable.
• Federal Reserve: Less guidance from the Fed is welcomed. A return to a less visible Fed, where less attention is paid to FOMC meetings and "smoke signals," would allow markets to step in and fill the vacuum, which is ultimately good for both markets and the Fed.