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Wall Street Earnings Expectations Ignore Economic Divergences

Bill Hester, CFA
July 2010
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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.

Analysts are heavily influenced by recent earnings performance. So it's not surprising to see the current high earnings expectations considering the strong rebound in S&P 500 earnings over the past year. But, in a year's time, the record suggests they'll likely be wide off the mark.

A more valuable indicator of future profits may be the ISM's manufacturing report. Even though manufacturing represents a declining share of economic output, it continues to be responsible for the some of the most volatile components of GDP - and corporate profits. The graph below compares the level of the PMI Index and the year-over-year changes in S&P 500 Index earnings shifted forward by six months (the blue line).

It's this correlation between manufacturing indexes and profits that can partly explain the weakness in the global markets during the last two months. That's because the US Purchasing Managers Index is not alone in looking as if it is rolling over. Of the G7 countries, 5 domestic PMI indexes fell last month. Germany's index was unchanged and Italy's rose marginally. China, Taiwan, Singapore, and India metrics have also fallen in recent data. While these indexes still sit above 50, indicating expansion, the shared peak, mostly in April, and decline in their levels has investors worried.

Economists are responding to the softness in the leading indicators. In their most recent survey, economists told Bloomberg they expect the U.S. economy to grow 2.8 percent in the third quarter, down from 3 percent a month ago. At the same time, stock analysts have continued to increase their estimates for earnings growth.

The graph below attempts to contrast the erosion in the global PMI indexes against the rising optimism of stock analysts. Six series of data are plotted: the changes in earnings expected for the companies in the S&P 500 and the Euro Stoxx Index, and four PMI indexes for the US, the Euro area, Germany, and China. Each of the series is indexed to 100 in April, the month where most of the PMI data peaked.

The chart shows the growing divergence between expectations for earnings and the global PMI indexes. These indexes will be important to watch over the next couple of months. As John Hussman noted in Recession Warning , three of the four metrics that provided a warning of an approaching recession in 2007 are in place. A drop in the PMI index to 54 or below is the remaining indicator in that original set of metrics that hasn't signaled. But the weakness in the growth rate of ECRI's Weekly Leading Index - which leads the PMI by about three months - when combined with the other indicators are currently enough to expect a period of renewed weakness.

Therefore there are two dynamics that are now in place that were also in place near the end of 2007. Global earnings expectations are climbing while global PMI indexes are declining and there is sufficient evidence in hand to be concerned about a period of renewed weakness in the U.S. economy. The graph below shows the period between 2007 and 2008 using the same indices (leaving out China in this case because its economy peaked in 2008). It shows the same divergence in earnings expectations and PMI indexes along with when the recession signal was given in 2007.

The spread between the changes in global PMI Indexes and global earnings expectations is an increasing concern, especially considering the evidence that increases the probability of renewed economic weakness. Earnings growth forecasts have never been higher measured by the median expectation. This alone, typically leads to poor stock performance. The growing gap between PMI Indexes and earnings expectations increases these potential risks.


The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.

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Estimates of prospective return and risk for equities, bonds, and other financial markets are forward-looking statements based the analysis and reasonable beliefs of Hussman Strategic Advisors. They are not a guarantee of future performance, and are not indicative of the prospective returns of any of the Hussman Funds. Actual returns may differ substantially from the estimates provided. Estimates of prospective long-term returns for the S&P 500 reflect our standard valuation methodology, focusing on the relationship between current market prices and earnings, dividends and other fundamentals, adjusted for variability over the economic cycle (see for example Investment, Speculation, Valuation, and Tinker Bell, The Likely Range of Market Returns in the Coming Decade and Valuing the S&P 500 Using Forward Operating Earnings ).

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