When Upbeat Analysts' Consensus Spells Danger

¹²When Upbeat Analysts' Consensus Spells Danger

By Spencer Jakab | 1 August 2010

As Charles Dickens might put it were he to toil on today's Wall Street, great expectations can lead to the very best and worst of times. At the moment, a bumper crop of corporate profit reports has helped US stocks shrug off economic worries and has prompted Wall Street analysts mostly to raise their estimates. Collectively they expect earnings for 2010 to be nearly 7 per cent higher than they did in January. These bottom-up forecasts call for the companies in the S&P 500 to grow earnings by 33 per cent this year and another 16 per cent in 2011.

Although it seems counterintuitive, this optimism could be setting stocks up for a fall. Ned Davis Research has looked at forward analyst expectations for earnings growth and calculated that annualised market returns dropped to negative 12 per cent when forward earnings expectations were 15 per cent or higher. Conversely, returns averaged 18 per cent when forecast growth was 5 per cent or less.

Recent stock market history saw an extreme example of this. Near the end of 2007, just after stocks hit their all-time high, analyst consensus was calling for the S&P 500 to earn a record $102.78 a share in operating earnings for the following year. One could have reached the same figure by just extrapolating the trend of the preceding few years but, as we now know, there was very little about that period that one could extrapolate into 2008 or 2009. Actual earnings for the year were $57.20, a little over half of expectations.

Bill Hester, a fund manager, has quantified this tendency of Wall Street's finest to forecast via the rear-view mirror. He calculates the correlation between earnings growth for the coming year and analyst expectations to be a mere 0.28, while correlation with the past year is a far higher 0.75. Though strategists are also prone to excessive optimism or pessimism, their top-down expectations actually tend to be more sober than thousands of individual analysts who miss the forest for the trees. Current operating earnings forecasts for all 500 index constituents are about a quarter higher than Standard & Poor's own top-down expectations.

But analyst consensus of operating earnings remains Wall Street's preferred benchmark. It now stands at $95.79 a share, valuing the market at a price-to-earnings ratio of 11.5 times. This is wildly optimistic.

Revenue growth is expected to decelerate to 6.3 per cent in 2011 from 8.8 per cent this year, which would normally be a fairly pedestrian pace. But revenue is intrinsically tied to nominal gross domestic product growth of the economies into which the companies in the index sell, plus any market share gains. US nominal GDP growth averaged 3.25 per cent in the past decade, but companies in the S&P 500 grew their sales by an extra 2.75 percentage points on average. Since nearly half their sales go abroad, this was helped by booming emerging markets and the big decline in the dollar, which translates to higher reported revenue.

With inflation tepid, global growth merely so-so and the dollar strengthening recently, nominal GDP is seen growing by only 3 per cent next year and sales may not do much better. It is possible to give the S&P 500's constituents the benefit of the doubt on revenue. What strains credulity far more are expectations that operating profit margins will reach 9.11 per cent next year, a level commensurate with the peak of the boom years.

As we now know, much of that profitability stemmed from a financial sector reporting artificially high profits during the housing boom. The long-run average going back to 1997 is just 6.8 per cent. So some awfully optimistic assumptions get us to next year's 16 per cent earnings growth. What if we plugged in revenue growth of 5.75 per cent, forecast nominal GDP growth plus the extra revenue growth that S&P 500 companies have enjoyed over the past decade, and then applied the average corporate margin? Earnings would be just $71 a share.

Such a back-of-the-envelope forecast is no substitute for Wall Street's 'wisdom'— indeed it is not even a forecast. But, just as professionals now value the market on 'cyclically adjusted' p/e ratios, it might provide a sounder basis for valuation. After all, there are few economic series that revert to the mean as reliably as corporate margins.

Plugging in these numbers, US stocks would be trading at 15.5 times 2011 operating earnings rather than a far more attractive 11.5 times. And, since operating earnings are on average about 19 per cent higher than reported net earnings, that would put the market's actual 2011 p/e multiple at a somewhat pricey 18.5 times earnings using normalised forecasts. Given today's bullish corporate headlines, it is understandably difficult and possibly premature to become cautious. Then again, analyst consensus has a nasty tendency to lure investors into trouble.