Sunday, 17 August 2008

Analysts Still Playing Catch-up on Earnings

A theme that I have been harping on for the best part of a year is earnings. Earnings cycles never last much more than about 5 years. However, analysts being the optimistic bunch they are, often project 10 or more years of steady earnings growth into their models.

Thus they never anticipate turning points in the earnings cycle and are constantly playing catch up all the way down. I've laid the evidence out for this many times. About 6 weeks ago in Analyst Earnings Forecasts Still Too Optimistic I commented that analysts forecasts for US 2Q08 operating earnings growth of -9.2% would end up being twice as bad when the earnings season was done. It appears I was being overly optimisitic.

Now with 88% of S&P500 companies having reported earnings, as seen below 2Q08 earnings slumped -29.3% year over year. Once again the analysts have been caught short and have forced to chase the numbers down.

But thankfully we can put this ugliness behind us. Next quarter is the first year over year earnings season since the credit crunch started and therefore the comparisons will be much easier. That is reflected in the analysts forecasts predicting 6.3% operating earnings growth in 3Q08.

Are these numbers justified? If you've been paying attention you should at least be a little skeptical. Are these forecasts simply a result of easier comps? Certainly some of it is but definitely not all. As you can see below, looking at the actual earnings numbers, analysts are expecting a significant improvement in 3Q08 compared to the previous 3 quarters.

What is the source of optimism that will see 3Q08 earnings significantly higher than the previous 3 quarters? Drilling down sector by sector we find the following below.

Financials are expected to turn around from a negative number to a positive. How the fortunes of financials are expected to turn around in the next quarter escapes me. Energy is expected to explode higher, an interesting call in light of what oil has been doing over the past month. Lastly consumer discretionary is poised to rebound. A big call in light of the fact that the rebate checks could not prevent 2Q08 earnings growth being the worst in some time.

Back in May in 1Q08 S&P500 Earnings Continue To Tumble I stated that the then positive forecast earnings growth for FY08 was "wildly optimistic." As can be seen below, analysts have finally come around to that reality with FY08 earnings expected to be down -2.1%. However that will also prove to be optimistic and will more likely show a double digit decline when all is said and done.

The last chart below is one that regular readers will be familiar with. Put simply it aims to show how long it took for earnings to recapture their former highs after previous earnings cycle peaks.

After the peak in June 1989 earnings did not hit new records until June 1994 - a full 5 years or 20 quarters later. Earnings then peaked again in June 2000 and didn't recover to the previous peak until December 2003, a full 3 and half years or 14 quarters later. Currently analysts would have us believe that the earnings peak in June 2007 will be surpassed in 4Q08, just 1 and a half years or 6 quarters later.

Once again the optimism of an early earnings turnaround is unwarranted. What started out as a credit event effecting financials has now spread to the wider economy and therefore the earnings of non-financial companies.

One last word on US operating earnings. Operating earnings are basically earnings before bad stuff, that means before all the financial companies writedowns. It also means before charges taken at GM and Starbucks. If those were included things would look much worse.