Why You Should Ignore Wall Street's Earnings Estimates

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If you have kids, you may remember the Sesame Street program, "Which One of These Things Does Not Belong Here"?

You may also remember the tune that went along with it, "one of these things is not like the others, one of these things just doesn't belong, can you tell which thing is not like the others, by the time I finish my song?"

We are about to play a similar game.

S&P Price Target Raised, Earnings Remain Flat

Over the weekend Bloomberg reported:

"The same analysts who lowered second-quarter profit growth predictions to almost nothing in 2013 are raising (S&P) price forecasts (SPY - News) . Standard and Poor's 500 Index earnings rose 1.8% last quarter, down from a projection of 8.7% six months ago, according to more than 11,000 analyst estimates.  The U.S. equity gauge will increase 8.9% to a record 1778, should their (updated) forecasts prove accurate."

Their reasons for upping their S&P target price (SSO - News) range from "Investor confidence is growing" to "the economy is gaining sustainable momentum." But if that's really the case, then why wouldn't you also expect earnings estimates to rise instead of their recent declines? 

How Bad is the Earnings Guidance for the Second Quarter? 

At Business Insider, they note:

"The percentage of companies issuing negative EPS guidance is 81%, if this is the final percentage for the quarter it will mark the highest percentage of companies issuing negative EPS guidance for a quarter."

So, let me get this straight; this is the worst quarter ever for earnings guidance, but Wall Street analysts still continue to raise their S&P price targets?! Looking at the recent trend of earnings estimates, one must really question Wall Street's ability (or CEOs' for that matter) to even predict earnings in the first place (more on that below).

In our latest ETF Profit Strategy Newsletter published 6/25 I looked at the very long term trend of earnings growth and I wrote:

"Throughout 142 years of history, investors should expect earnings to decline 10% year over year on average once every five quarters, and an earnings decline over 20% should be expected 10% of the time, or once out of every ten quarters (2.5 years)." 

It has now been four years since we have seen any significant negative earnings growth.  In that analysis it was also very clear that earnings do not grow positively into perpetuity, and after four years since any significant decline, the business cycle may be ready to again take hold.

Rising Prices on Lowered Earnings

In an example from the first major S&P component to report, Alcoa's (AA - News) Q2 adjusted earnings of $0.07 "beat" its estimate of $0.06. 

Not mentioned by the news sources though is that Alcoa's Q2 earnings estimate was way up at $0.60 in early 2011 and at $0.28 last year.  The company has dropped their earnings estimate by over 90% since they started giving guidance.  With estimates that far wrong, it is amazing we put any trust in estimates in the first place.  

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When prices rise (IWM - News) and earnings do not, this means one thing - that investors are paying more for a product that is delivering less.  But, starting out with extremely high estimates that are then dropped through time is nothing new. 

The charts below from Standard and Poor's show this trend for the S&P 500 over the last two years.  A look back since the 90's shows this practice is actually the norm (see my article on not getting "duped" for the longer term view of earnings estimates which pretty much every year are adjusted downward). 

Reality shows that S&P earnings estimates have been declining since 2011, meaning prices (along with P/E ratios) are rising (DVY - News) for reasons beyond underlying fundamental expectations.  This also means investors have been paying more, and getting less during that time.

Whatever the reasons, without earnings to eventually accompany, share price (SPXS - News) growth is likely unsustainable over the longer-run.

Figure 1: Can You Find the Outlier?

View photo

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The first two charts above show how analysts have been lowering earnings guidance for well over two years now.  Estimates were lowered around 10% by the 3Q of 2012, and down over 15% to just $97 by the time 2012 was completed (not shown).  This resulted in a P/E ratio (UPRO - News) that jumped from 12x to 15x by Dec 2012. 

Again, the latest earnings estimates for 2013, have been significantly lowered through time, also down around 10% (so far) and also resulting in a significantly higher real P/E ratio, currently over 16x (IVV - News).  If earnings continue to decline, this just means the P/E will go higher. 

One of These Things does not Belong Here

Looking at the final chart above of 2014 earnings estimates, we see a a chart that clearly does not look the same.  For the first three months 2014 has been estimated, earnings are expected to be higher and rising, as businesses are still focusing on 2013. 

The same thing occurred with 2012 and 2013's earnings estimates that were also initially expected to rise.  That is until reality set in, CEOs started to get visibility, actual earnings started to disappoint, and future estimates were finally lowered. 

2013's decline continues today as the 2013 chart in Figure 1 above shows.  If 2012 is any lesson, it would not be surprising to see 2013 earnings follow 2012's footprint and continue to be ratcheted down through December.

For now 2014's estimates remain the odd chart out, that is until CEOs start to actually look at the significantly higher 2014 earnings targets and also start ratcheting them down. 

Given Wall Street's horrid history of earnings estimates, we should expect 2014 earnings estimates to eventually be pulled back as 2013 estimates continue to disappoint. 

The latest ETF Profit Strategy Newsletter includes a detailed analysis of various market forecasting tools, along with a short, mid, and long-term outlook for the U.S. stock market.  Updates through our Technical Forecast are provided every Sunday and Wednesday nights.

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