There’s an odd disconnect in the marketplace.
Economists have been revising their economic forecasts lower for months, and yet for the most part the reports on GDP growth, exports, housing, manufacturing, retail sales, consumer confidence and the like have been even worse than those lowered forecasts.
Yet Wall Street has continued to ratchet up its forecasts for corporate earnings. The consensus forecast is now for S&P 500 earnings to be up 35% this year, and another 26% next year. That’s up from the forecasts in January that earnings would be up 25% this year and 19% next year.
The divergence between sharply declining economic forecasts and sharply rising corporate earnings forecasts does not seem to compute. But even ignoring the slowing economic growth, the very optimistic earnings estimates by themselves may be a warning sign.
A recent study by highly respected Ned Davis Research Inc, found that on average when the consensus estimates call for earnings growth of more than 15%, the stock market has subsequently fallen an average of 12%. In the other direction, when estimates are for earnings growth of 5% or less, the S&P 500 has averaged a subsequent gain of 18%. In other words, Wall Street tends to be overly optimistic at the wrong times, not seeing, or at least not acknowledging, when trouble is coming for earnings.
The current forecasts for exceptional earnings growth going forward have been very important, focusing the market’s attention on 2nd quarter earnings in July, allowing it to pretty much ignore the increasingly dismal reports on global economies. It’s understandable then that Wall Street is reluctant to start bringing those earnings estimates down.
But it looks like they are now behind the curve and must begin the process - if they’re going to meet the realities of what companies and the economic reports are saying. It would be far better to begin revising earnings estimates down so they will still be easy for corporations to beat, than to leave the estimates too high and have companies miss them by wide margins.
And we have been seeing the earnings reality change, with earnings warnings from a growing number of key companies recently as they reported their 2nd quarter earnings, including giant consumer product companies Proctor and Gamble (PG), Unilever, and Home Depot (HD), and numerous retailers, as well as a slew of technology and IT companies like Cisco (CSCO), Intel (INTC), Apple (AAPL), Dell, Nokia (NOK), Nvidia (NVDA), EDS, all cutting their guidance for the rest of the year and into 2011 in analyst conference calls after releasing their 2nd quarter earnings reports.
Wall Street cannot ignore that changing guidance, not with only seven weeks left before the 3rd quarter earnings reporting period begins.
