Stormy Weather

by: Keith Summers, CFA

Sandy Damage Estimate Raised to as Much as $50 Billion - Bloomberg

That title quote was from the news service, not the mayor. And no doubt about it, $50 billion is a lot of money. But just to help put that into perspective - U.S. GDP is $41 billion, per day. So, while the human and property damage is immensely catastrophic, the clean-up and repair costs are not going to nudge the U.S. economy too much one way or the other.

The economy, we are led to believe, improved in the third quarter of 2012 with "real" GDP growing at a 2% annual rate. And, if you're a little skeptical about how the inflation rate is calculated, nominal GDP grew in the third quarter at a 5% annualized rate, which is an acceleration over the year-over-year growth rate of 4%. As the rest of us in the "real world" don't get to report sales or earnings on an inflation-adjusted basis, we actually kind of prefer nominal GDP to its inflation-adjusted alter-ego.

But, even though economic growth picked up a little bit, corporate earnings, as disclosed in this most recent earnings season, didn't quite meet the expectations of stock analysts. Yet earnings forecasts are still calling for growth, just less growth than before.

What are we to make of forecasts that are clearly not apocalyptic, but less rosy than they used to be?

Table 1 Forecast Growth in Earnings per Share

Oct. 2013 vs. Oct. 2012

Sept. 2013 vs. Sept. 2012

S&P 500

9.8%

10.3%

MSCI ACWI

20.5%

23.8%

US Small Cap

36.8%

36.7%

Europe

19.3%

19.8%

Brazil

41.6%

42.1%

Russia

5.9%

4.6%

India

20.2%

18.5%

China

14.5%

13.7%

Click to enlarge

Two things are obvious, 1) earnings growth is expected to vary widely between countries, and; 2) foreign firms are expected to grow their earnings faster than U.S. firms. But before we go any further, what happened to last year's forecasts?

Table 2 Annual Growth in Earnings Per Share

Actual EPS Growth,

Oct 2012

Forecast EPS Growth, Oct 2011

S&P 500

7.7%

11.8%

MSCI ACWI

(3.8%)

21.5%

US Small Cap

3.8%

29.6%

Europe

(13.3%)

14.9%

Brazil

(40.3%)

2.9%

Russia

(4.2%)

25.0%

India

(7.2%)

18.6%

China

(2.4%)

15.0%

Click to enlarge

Again, two things are obvious: 1) analysts' forecasts for earnings growth were overly optimistic and; 2) many companies saw their profit margins shrink, and in some cases disappear. Given the experience of the last 12 months, how confident can we be of analyst estimates?

We examined the analyst accuracy for earnings forecasts over the last seven years and found that the country experience varied widely. U.S., Chinese and Russian firms came the closest to meeting median expectations while corporate profits for the global index were over-estimated by 13% or more, 50% of the time.

Table 3 Analyst Forecast Optimism

Median Analyst Forecast Overestimate

S&P 500

5%

MSCI ACWI

13%

US Small Cap

14%

Europe

20%

Brazil

14%

Russia

(3%)

India

17%

China

6%

Click to enlarge

So, most of the time, most of the analysts are too optimistic - looking twelve months out. Earnings forecasts are like weather forecasts, frequently inaccurate, sometimes really wrong, but at the end of the day, helpful in identifying risk.

What are the telling us now? A year from now, profits (and stock prices) will both likely be higher but that we should keep a weather eye on the economic horizon.

The storm clouds haven't cleared yet.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.