Monday, 3 March 2008

S&P500 Earnings Forecasts Still Too Optimistic

As of February 26th 4Q07 earnings season is set to go down as one of the most ugly in recent memory. With just a few S&P500 companies left to report, year over year operating earnings for the S&P500 is showing a decline of -23.9%. That makes it the worst earnings season in 6 years when earnings declined -24.2% in 4Q01.

However that hasn't prevented analysts from donning their rose-colored glasses when it comes to forecasting earnings for 2008. 1Q08 and 2Q08 forecasts have continued to edge down slightly now sitting at 0.9% and 1.0% growth respectively. That's still optimistic in my book.

If the US economy is indeed in a recession, it would be remarkable for corporate profits to turn positive after just 2 negative quarters. Back in the 91 recession earnings growth was negative for 5 consecutive quarters from 4Q91 - 4Q92 inclusive. In the 2001 recession earnings also registered negative year over year growth rates for 5 consecutive quarters from 4Q00 - 4Q01 inclusive.

Of course, this time could be different and it is not my intention to suggest that it is impossible for earnings to turn around abruptly, just that it is unlikely given previous earnings recessions. However if you're not convinced that analysts are too optimistic for the first half of 2008 maybe you'll agree they have their heads in the clouds when it comes to 3Q08 and 4Q08.

Just a glance at the chart above is enough to set off alarm bells. The blue line represents current analyst forecasts. After more or less flat growth in the first half S&P500 operating earnings are expected to rise 20.5% in 3Q08 whilst 4Q08 is expected to show earnings growth of a staggering 59.2%. Yes the comps for third and fourth quarter earnings are much easier than for the first two quarters of 2008, however this would represent an unprecedented earnings recovery based on the last 20 years of history.

Year over year quarterly earnings tend to peak shortly after a recession precisely because the comparable quarter's earnings are poor. However, even following the 1991 recession year over year quarterly earnings growth topped out at 35%, after the 2001 recession earnings growth topped out at 29%.

Again, this not meant to say that year over year quarterly earnings growth can't exceed 35% but rather, that a forecast of 59% growth is highly dubious. One further point to note. Corporate profit margins over the last 5 years are at record highs. Given some type of reversion to the mean, (that has already started to show up in some company reports) it is possible that the earnings recovery this time round will be more subdued than previous cycles.

That analysts are slow to revise their forecasts at earnings cycle turning points is not new. Like economists they rarely see turning points coming. So don't hang your hat on current earnings forecasts, they are bound to change and change dramatically. After all, remember that analysts were still expecting positive year over year quarterly earnings growth for 4Q07 as late as mid November. How did that turn out?