Consensus Estimates Too High Entering Earnings Season

Early Saturday, I was reviewing YTD returns by sector on the S&P website when I decided to click on a link with which I was unfamiliar, “Operating Earnings and Estimates by GICS Sector” (excel doc). While I wasn’t too surprised by what I saw, as it confirmed what I have observed in general when I look at individual stocks, it was nevertheless very interesting:

click to enlarge

I highlighted the numbers that jumped out as outrageously high. I was surprised minutes later to read in Barron’s (subscription required):

As we have written before, consensus earnings estimates for 2008 aren't credible. Our own Standard & Poor's 500 profit numbers will be at least $10 below analysts' numbers. A dichotomy exists between what industry analysts say and what portfolio managers believe may be priced into the market. In the past three months, when the economic data were far weaker than many people expected, and third-quarter earnings came in well below consensus expectations, Wall Street analysts cut their 2007 estimates but barely touched their '08 numbers. Portfolio managers have adjusted their '08 expectations….

At year end the consensus estimate was approaching $105. A more likely expectation is $90 to $95 for 2008. When fourth-quarter results come out, we'll look to see whether companies have used what wiggle room they have to keep the '07 numbers as low as possible. It may be a good tactic to push up reserves or defer good news because '08 comparisons will matter more than fourth-quarter results.

Were these the comments of perma-bear Fred Hickey? No, surprisingly, Abby Joseph Cohen of Goldman, Sachs, who despite having a year-end target of 1675 (+14%), shared what I view as a catalyst for lower prices in the interim. Unlike her, I believe that most investors don’t yet grasp fully the extent of the exaggeration in the earnings estimates.

I expect that earnings for the S&P 500 will be no higher than 80 (-5% to -10% from 2007, which isn’t yet fully reported and likely to be lower than the 87.45 currently projected). While I would expect the forward PE to not decline further, I don’t look for it to expand much this year, as I expect longer-term yields will rise and credit spreads will remain wide. If I use the current 14.5 forward PE and project 10% growth in 2009 (88 EPS), I get a year-end target of 1276 (-13%). This target ties in with a more technical/seasonal approach that I will share below.

Why am I (and Abby) so negative on earnings growth this year? It’s all in the margin. As I wrote in October, when I warned that investors should be building an ark to protect themselves from the coming storm:

I am negative generally on earnings growth as I believe that many of the sources of growth in recent years are dissipating: Leveraging balance sheets to repurchase stock, productivity improvements and outsourcing to India and China are all relatively mature. The low-hanging fruit has been harvested. If one looks at margins across the S&P 500, they are very high historically, especially when one considers that they now include options expensing. Further, in a slower growth or recessionary environment, earnings are harder to grow as well. We are in our sixth year of EPS growth for the S&P 500, which is unprecedented in recent history. In fact, they are expected to rise yet again next year. In the last recession, EPS fell sharply and quickly, while in the early 90s they fell something like 10% per year for three years.

Recently, some of the pressures have become very visible, with energy prices and agricultural products remaining high. While one might expect labor costs to moderate, I tend to think that companies are unlikely to jettison employees as readily as they have in the past, for they have learned how hard it is to replace them later. With employees getting squeezed on many of their costs (food and energy, taxes, adjustable mortgages), I expect to see companies not only retain them but continue to adjust wages and benefits higher. In any event, here is a visual to illustrate the whole margin issue:

In recessions, earnings decline (the green line above). I am hopeful that this will be a nasty, brutish and short recession, though I am open minded to the possibility that it isn’t. If I am correct, maximum pessimism should occur right around the election. For long-only investors who have to be invested, I highly recommend heavy exposure to Healthcare and Energy and to invest in companies in other sectors where the management team is realistic about the current environment and where the risk to margins is below average. I continue to be very negative and expect to profit mainly from the short-side this year. I have specifically shared the following forecast recently with my clients (the green line is my expected low; the red line is my expected 12/31 price):
➢ S&P 500 bottoms near-term in April near 1320
➢ Retracement over next 45 days or so is to 1430 (a little higher than now)
➢ Final leg down into the fall gets to 1150-1240 (best guess is 1160)
➢ We rally in Q4 - I would guess 1275-1285

Keep in mind that hope is not an investment strategy! If you are counting on fiscal stimulus or dangerously low short-term interest rates to prop up stocks, you are in for disappointment. Transparency and accountability in our financial system are the pathways to the quickest recovery for stocks. The economy will inevitably contract, but today’s headwinds will decelerate. Just like the overhang from the S&L debacle, the multiyear pressure of excess real estate supply will allow the economy to experience years of low inflation. We just have to get through this period of full acceptance of how the consumer, which represents the largest portion of our GDP, will be constrained for the next several years relative to the profligate borrow-and-spend ways of the past decade or so.

Disclosure: Today I am a bear, unfortunately, but I am optimistic that I will become a bull later this year.

Comments

[EasySolution]

If you know it is getting into recession and yet you will be bullish by end of the year, what changes cause you to be bullish ? Is it rsing wage ? Is it richer foreigner to buy US cheap assets ? May be those bankrupt subprime subscriber magically getting rich again ? Or it is only because the market has been corrected so much. If it is the last case, market won't exceed past new high since there is no new demand.
S&P will stay under 1550 for 5 years, 10 years or even longer.
If we know why US is going into recession and why it will be recovered, why can't we short circuit the two events and avoid the downturn ?

[WAKEUP]

You still don't quite get it, Alan. Here's the short version: The consumer is broke. Yes, I know Mr./Mrs./Ms. Consumer still have a few hundred dollars of mad money tucked away, but that will be gone, in short order. Consumption is going to fall 'way off, in the coming six months, or so, and it will stay off for a very long time. Employers WILL dump employees in the same profligate manner as in previous "tough times." Unemployment and underemployment will be high, for years. Credit will be difficult to get. Hence, not much money in consumers' pockets equals not much consuming going on. Beans and rent will be the priority items. Used furniture stores are going to be a good bet.

[AlanBrochstein]

Well, I am not so sure that you and I are that far apart on the state of the consumer. It sounds like we disagree on perhaps what it means for stocks (I would argue that stocks have figured it out for the most part) and definitely on the employment front. A typical recession sees job losses of 200k per month. I don't know what the basis is for your argument, but I would suggest that just as we didn't see the growth hit the typical +400K peak, we won't see those kind of numbers. I expect the job loss in this recession, which will be dated from ??? to ??? (the way the bean-counters do it, probably Q2-Q4) to be about 1mm to 1.5mm only over the 9 months or so.