Why Investors Should Focus Their Anger at Wall Street

by: AAII

The question I’ve routinely been asked since last Friday is: "what do you think about Goldman?" My answer is the only shocking event was that Goldman Sachs (NYSE:GS) was actually accused of having its hand in the cookie jar. This is not to say that GS is guilty, but the fact that rules were allegedly broken is not something that raises my eyebrows.

The simple fact is that there is too much money, too much competitiveness and too many type-A personalities for rules not to be broken. To be fair, however, there are many honest people working on Wall Street as well.

Though there is reason--between the bonuses and the accusations--to be mad at Goldman, you should really save your anger for brokerage analysts. Once again, they are showing a complete inability to forecast corporate earnings. According to the latest numbers from our friends at Standard & Poor’s, more than 80% of large-cap companies topped first-quarter expectations by a margin of 2% or more as of Wednesday.

I realize that the relative improvement in economic conditions is helping to improve margins, but aren’t analysts being well compensated to know a company inside and out?

Take McDonald’s (NYSE:MCD) for instance. The company publicly releases sales data every month. Many of the other factors that influence earnings (e.g., commodity prices) are also widely available. Yet, the fast-food chain surpassed quarterly estimates by 7%. That is not just an earnings beat; it is a complete miscalculation by the analyst community.

I like seeing positive surprises just as much as the next person. I also really like seeing earnings estimates revised higher. The problem, however, is one of valuation. Most, brokerage price targets are based on forecast earnings or cash flow. If analysts can’t even get the numbers right for the most current quarter, why should we think they are right about 2011 profits?

The valuation question partially explains why the markets pulled back in July, October and January following the release of better-than-expected earnings. Traders factored in a margin of error and when the actual numbers came out above the forecast numbers, stocks were sold. This morning’s decline not withstanding, it remains to be seen whether this cycle is about to repeat. (Given that the current leg of the rally is long in the tooth, I do expect a decline to occur sooner rather than later.)

Short of company guidance, individual investors have little go on other than analyst estimates, so we are stuck with them. However, given the likelihood of error, it makes sense to follow the lead of the institutional investors and allow a margin for error when determining a company’s valuation based on forecast earnings.

Be mad at Wall Street, but be rational. Investing has never been an exact science, rather a messy one. As long as the potential rewards outweigh the potential risks, a stock is likely worth owning. Just realize that the possibility for error always exists.


First-quarter earnings season continues with approximately 150 S&P 500 companies scheduled to report. Dow components will include Caterpillar (NYSE:CAT) on Monday, DuPont (DD) on Tuesday, 3M (NYSE:MMM) on Tuesday, ExxonMobil (NYSE:XOM) on Thursday, Procter & Gamble (NYSE:PG) on Thursday and Chevron (NYSE:CVX) on Friday. Other notable companies on the docket are United Parcel Service (NYSE:UPS) on Tuesday and Visa (NYSE:V) on Wednesday.

The Federal Open Market Committee (aka "the Fed") will hold a two-day meeting starting on Tuesday. No change will be made to interest rates. The meeting's statement, scheduled for release at about 2:10 ET on Wednesday, will be scrutinized for any suggestion the Fed is close to dropping language that rates should be kept at low levels for "an extended period."

On Friday, the initial estimate of first-quarter GDP (gross domestic product) will be published. The consensus among economists is for economic growth of 3.5%, according to Briefing.com. Other notable economic data will include the S&P Case-Shiller housing index (Tuesday), the Conference Board's April consumer confidence index (Tuesday) and the University of Michigan's final April consumer confidence survey (Friday).

The Treasury department will hold several bond auctions, totaling $129 billion. Five-year inflation-adjusted notes will be offered on Monday, two-year Treasury notes will be sold on Tuesday, five-year notes will be auctioned on Wednesday and seven-year notes will be offered on Thursday.

No Fed officials are scheduled to make public appearances.