ANALYSIS:Euphoric predictions require pinch of salt as optimism bias continues to bedevil forecasters, writes PROINSIAS O'MAHONY
EARNINGS SEASON concluded last week in the US, and it was a strong one – the vast majority of companies beating expectations.
Analysts foresee more of the same in the coming quarters, projecting record earnings for SP 500 companies in 2011. New research, however, indicates that investors should take such predictions with a grain of salt – chronic over-optimism has bedevilled the analyst community over the last 25 years, with earnings growth estimates “nearly 100 per cent too high”.
According to global consulting outfit McKinsey, companies have grown their profits by 6 per cent annually during that period. Analyst growth forecasts of 10-12 per cent have been almost twice that figure.
Actual earnings have exceeded forecasts on only two occasions, McKinsey notes, with both occurring in a post-recession recovery. Earnings only “occasionally coincide” with analyst forecasts and do so during periods of exceptionally strong economic growth, as occurred in the credit-fuelled years prior to the global financial crisis. Slow to adjust their forecasts, the researchers found that analysts typically lag behind events, and the gap between expectations and reality widens dramatically during economic downturns.
The research confirms the findings reached by McKinsey in a similar study conducted nearly a decade ago. Regulators and investors will be disappointed that nothing appears to have changed.
The unearthing of tainted analyst research caused a major scandal in the aftermath of the dotcom crash, triggering $1.4 billion in fines and a series of rules and regulations designed to restore investor confidence, while also improving earnings forecasts.
Why the continued inaccuracy? Psychologists speak of optimism bias and our seemingly in-built tendency to take an overly sunny view of matters. Analyst and behavioural finance expert James Montier, meanwhile, has written about a “fallacy of composition problem”. Most analysts will happily concede that overall estimates may be too high, Montier said, before going on to assert that their own projections for the companies they cover are perfectly reasonable. Others scoff that most analysts are little more than salesmen who inevitably cheerlead for the stock market.
Whatever the reason, there’s no doubting that analysts are expecting big things for the remainder of 2010 and 2011. Bloomberg estimates show that analysts expect profits to soar by 19 per cent this year, the biggest jump since 1995, while further growth of 18 per cent is projected for 2011.
Earnings bulls can point to the fact that 77 per cent of companies beat expectations in the last quarter, and that similarly exceptional “beat rates” have been delivered over the last number of quarters. Still, consecutive years of earnings growth of this magnitude have never before been delivered. Earnings estimates for 2011 are higher than the record earnings recorded in 2006 – at the height of the consumer credit binge.
Not all analysts are so rosy, however. Standard Poor’s index analyst Howard Silverblatt has warned that macroeconomic analysts taking a “top-down” earnings calculation arrive at estimates that are approximately 32 per cent lower than those of their “bottoms-up” colleagues. The latter focus on individual companies, while the former take a more removed view of the overall economic picture.
“From the bottoms-up view, it’s always great tomorrow,” Silverblatt noted. Historically, however, “the top-down view has a better track record of realising there’s a problem”.
Silverblatt’s research adds weight to James Montier’s theory. That is, excessive optimism may be the product of an analyst’s individual attachment to certain stocks – a mistaken notion that they are somehow immune from the overall economic cycle – rather than some cynical attempt to pump share prices higher.
Either way, the hopelessly optimistic estimates of the last quarter century indicate that investors should be sceptical of today’s euphoric assessments of future profitability.
