Wall Street Catches Up with the Rally

07/27/2009 2:50 pm EST

Focus: MARKETS

Jim Jubak

Founder and Editor, JubakPicks.com

Call it the overreaction 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 bullish investors to keep on buying.

In June, Wall Street analysts raised their earnings forecasts for companies in the Standard & Poor's 500 index 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, the S&P 500 should trade at 1233, about 26% above the July 27th 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 keep 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 analysts missed the mark back then than they do with expert, inside knowledge about future business conditions.

In the fall of 2008—a year after the stock market had peaked—Wall Street was caught flat-footed in its optimism when Lehman Brothers 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 9th, 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 overreacted to its earlier late reaction. Of the 205 companies in the S&P 500 that had reported as of July 24th, 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’s 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 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, but they don’t tell us much of anything about when the economy will reach its turning point.

For more of Jim Jubak’s stock picks and market commentary, go to his blog Jubak Picks.

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