This article is a guest contribution by Bill Hester, CFA, Hussman Funds
July 2010
This week brings the official start to second-quarter earnings announcements. As the mechanism for data delivery gets switched from the faucet to the fire hose, investors may want to keep a few things in mind as the reporting season progresses. Lofty earnings expectations result in poor stock market performance, on average. Forecasts for expected earnings are typically the most misleading at economic inflection points. And less frequent and less celebrated data such as the Purchasing Managers Indexes may provide a better view of future profits than analyst's expectations. The diverging trend between the PMI data and earnings expectations will be important to watch.
The chart below gives one perspective into how bullish stock analysts currently are. The data is compiled by Ned Davis and it shows the median estimated one-year earnings growth rate for the companies in the S&P 500. Analysts are now forecasting more than 21 percent earnings growth for the median stock over the next year, a record level in the 30 years of data.
As Ned Davis has noted, stock returns are usually considerably weaker beginning from periods with high earnings expectations. The stock market has risen 18 percent on an annualized basis when earnings expectations are below 5 percent. When expectations rise above 15 percent, annualized total returns fall to -12 percent. Stocks are more vulnerable when robust earnings growth is already assumed by investors.
Projected earnings growth by Wall Street analysts is also far less "forward looking" than one might imagine. The graph below plots the median expected 12-month forward growth rate expected by analysts, along with the percentage change in actual S&P 500 earnings per share over the preceding year. At each point on the graph, the growth rate that analysts expect for earnings over the next year is plotted with the actual change in earnings over the prior year. The graph shows that they shadow each other closely. This suggests that forecasted earnings for the next year are little more than an extrapolation of the change in earnings over the prior year. The correlation between year-ahead earnings growth expectations and the actual growth in earnings over the same period is .28 (statistically, this means that Wall Street's forecasts explain less than one-tenth of the variation in actual earnings growth over the following year). The correlation between year-ahead growth expectations and the change in earnings over the prior year is .75.
