At Ockham, we often like to check in on the prevailing school of thought among Wall Street analysts. Study after study has shown the analyst community to be woefully inaccurate at predicting corporate profits. They are historically an overly bullish group as the a McKinsey report recently observed, over the last quarter-century Wall Street analysts’ earnings estimates have predicted on average nearly 100% too high a growth rate, as the average predicted growth rate of 10% to 12% has clearly overshoot the reality of about 6% annual growth (The Analysts’ Horrendous Track Record Exposed). In that 25-year time span only two times have the analysts been too bearish compared to actual earnings, and this was in the recovery phase of the business cycle after a recession. Of course, analysts come out looking most overly bullish and almost silly when recessions hit or bubbles burst.
To be fair, no one can accurately predict the future, and only a rare few see bubbles for what they are before it is too late. However we found it fitting that the analyst bulls on Wall Street seem to have taken firm control yet again and expectations for the coming years are extremely aggressive. According to Thomson Reuters analysts have predicted 2010 earnings to $82.26 per share, which is clearly phenomenal growth of around 40% from the level of 2009. While this growth is certainly possible, we think it is a lofty expectation and one that may prove to be too much with top-line growth still elusive.
However analysts are even more bullish towards calendar year 2011 as Thomson Reuters now shows the consensus among analysts calling for S&P 500 growing earnings to a new record $96.25. For earnings to come in that strong they would need to grow another 17% on lofty 2010 expectations. Furthermore, this would top the peak earnings levels achieved in 2006 by about 9%. Remember in 2006, a large portion of S&P 500 earnings were produced by the overleveraged, high-flying financial sector as well as ballooning profits from energy companies. The situation has changed dramatically since then and we think it is unreasonable to expect that large a contribution from financial stocks post FinReg.
The analysts would surely argue that firms have aggressively cut costs and have made themselves more profitable, so should revenues really start to rebound there would be a multiplier effect on earnings per share. This is of course all true, but with the analysts’ track record in mind we think it is wise to at least be skeptical as to their abilities and wary of the tendency to exaggerate. I do not need to list a number of pitfalls that have the potential to further drag on the US economy because most are already well known. Instead, we will conclude with a warnings issued in John Hussman’s weekly market comment.
I continue to urge investors to have wide skepticism for valuation metrics built on forward operating earnings and other measures that implicitly require U.S. profit margins to sustain levels about 50% above their historical norms indefinitely. Forward operating earnings are Wall Street’s estimates of next year’s earnings, omitting a whole range of actual charges such as loan losses, bad investments, restructuring charges, and the like. The ratio of forward operating earnings to S&P 500 revenues is now higher than it has ever been. Based on historical data (see August 20, 2007 Long Term Evidence on the Fed Model and Forward Operating P/E Ratios), the profit margin assumptions built into forward operating earnings are well beyond two standard deviations above the long-run norm. This is largely because, as Bill Hester noted in his research article last week, forward operating earnings are heavily determined by extrapolating the most recent year-over-year growth rate for earnings. In the current instance, this is likely to overshoot reality, and in any event, has little to do with the long-term cash flows that investors can actually expect to receive over time.
I can’t emphasize enough that when you hear an analyst say “stocks are cheap based on forward operating earnings” it would be best to replace that phrase in your head with “stocks are cheap based on Wall Street’s extrapolative estimates of a misleading number.” – John Hussman, Ph.D Don’t Take the Bait 7/19/2010