How long can the rally run? How fast can Wall Street raise earnings estimates?

07/27/2009 3:32 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Call it the over-reaction reaction. Now that stocks are rallying and companies are beating Wall Street earnings estimates, Wall Street analysts have started to raise their projections for 2010 earnings.

The move may not be based on real fundamentals, but it will provide a good excuse for investors who want to buy to keep on buying.

In June Wall Street analysts raised their earnings forecasts for companies in the Standard & Poor's 500 896 times and lowered them 886 times, according to JPMorgan Chase. That's a slim margin, but it's the first month since April 2007 that analysts have raised estimates more than they've lowered them.

That net optimism has pushed June forecasts for S&P earnings to $74.55 a share. In May estimates for 2010 stood at $72.54.

That gives bulls who want to keep on buying all the rationale they need. If you multiply that $74.55 a share in forecast earnings for 2010 times the five-year average price-to-earnings ratio for the S&P 500 of 16.54, then, presto chango, the S&P 500 should trade at 1233, about 26% above the July 27 price of the index.

I think this shift in opinion is an important short-term indicator of stock market sentiment. Rising analyst projections like this do provide a powerful boost to investors looking for a reason to kee buying into a rally. The shift is a sign that this rally could run for a while longer.

But analyst opinions tend to be a trailing indicator. Even though they're called forecasts, they have more to do with what the market did in the past and how badly analyst estimates missed the mark back then, than they do with expert, inside knowledge about future business conditions.

Let's look at recent analyst forecasts as trailing indicators.

In the fall of  2008--a year after the stock market had peaked, remember--Wall Street was caught flatfooted in its optimism when Lehman Brother's failed. Analysts rushed to cut estimates. In October 80% of the 4,700 earnings revisions were downward, according to JPMorgan Chase. And they kept on cutting as the recession unrolled and as analysts continued to play catch up. By January 9, just before earnings season started, Wall Street was forecasting that fourth quarter earnings would tumble by 20%. Whoops! They fell by 61%.

Wall Street finally caught up with the economy by the second quarter of 2009--in fact it looks like Wall Street over-reacted to its earlier late reaction. Of the 205 companies in the S&P 500 that had reported as of July 24, 75% had beaten Wall Street estimates, according to Bloomberg.

A lot of the excitement about second quarter earnings being better than expected is an artifact of Wall Street cutting estimates too far in an effort to catch up with where the real economy had been.

Most of those earnings surprises have come as a result of cost cutting at companies. If you cut 6,000 people go and slash your capital spending budget, yes, you can indeed show a big increase in short term earnings. (Especially since the most followed earnings numbers take out such one time costs as downsizing a workforce.)

The sales and revenue numbers for the second quarter show a contrasting, and, I would argue, more accurate picture of where we are in the recovery. Although 75% of S&P 500 companies reporting beat earnings estimates, only 50% exceeded Wall Street projections for sales, again according to Bloomberg.

So take Wall Street earnings estimates for what they are in the short run--indicators of market sentiment. Right now they're telling you that this rally still has life. Just don't believe that they tell us much of anything about when the economy will reach its turning point.

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