Those Earnings Revisions
A little chart candy this morning. Note the rebound in expectations and positive revisions in late 2008 – early 2009. The bar was set low for the hostess-twinkie recovery. At that time we offered the following thoughts to investors as we approached last year’s monster rally:
“Economic conditions are likely to remain challenging throughout the year, but the amount of stimulus building in the pipeline makes a cyclical rally in equities increasingly likely. We are certainly not wildly bullish today, but we believe most of the perceived threats are priced in and we have likely experienced “the point of maximum pessimism” which has historically represented a tremendous opportunity for long term investors. Lower prices and reduced risk levels, combined with exploding liquidity and extremely oversold momentum, are conditions typical of powerful advances in equities.”
Fast forward to today. Revisions have clearly peaked and are declining sharply at the same time the bar has been moved substantially higher. Not pictured here are valuations that have also moved steadily higher alongside the bar, meaning downside risk has increased from today’s artificially inflated levels. Consensus earnings estimates for 2011 and 2012 are still greater than $95 and $108, respectively, at the same time that GDP estimates are plummeting (although still don’t face the harsh economic reality). To put these figures into perspective, analysts were forecasting a near 20% decline in earnings at the market’s trough. Today, expectations are for 22% growth in the year ahead. The average annual gain on the S&P when earnings growth estimates have been below 4.2% has been a positive 17.2% return, consistent with last year’s monster bear market rally. Regrettably, the average annual performance of the S&P when earnings growth estimates have been above 14.2% has been a decline of 4.6%.
The weight of the evidence clearly points to a double dip. There are no guarantees in this business, but we put the odds at near certainty (if we ever escaped the clutches of recession in the first place). Those that can’t see this, simply don’t want to. The best argument we’ve heard to date against another contraction in the economy, is that ‘double dips are extremely rare.’ So are national house price declines, developed world sovereign debt defaults and the associated and extended deleveraging processes. We’d humbly suggest that ignoring these so-called ‘rare’ risks may not be beneficial to long term returns, particularly in light of today’s elevated valuations and lofty expectations. Caveat emptor.