Consider a study from James Bianco of Bianco Research. It looks at two groups of earnings estimates, one from Wall Street strategists who look at the macro picture, and, second, the Street’s analysts who study individual firms. According to most recent recession earnings forecasts:
●1990-91 recession: Strategists (top-down forecasters) were too optimistic by 10 percent. Analysts (bottom–up forecasters) who added up the 500 company forecasts, were too optimistic by 25 percent.
Series: Breakaway Wealth
●2001 recession: Strategists and analysts too optimistic by 23 and 25 percent respectively.
●2007-09 “Great Recession”: Strategists and analysts too optimistic by 40 percent.
As Bianco notes, both strategists and analysts are getting significantly worse at predicting future earnings.
Doug Kass, who manages the Seabreeze hedge fund, thinks other factors are at work. Kass, who has been critical of Wall Street analysts, points to distinctions between cycles. “If you go back over the last eleven recessions — the first nine all had 5 to 15 percent profit drops. Perhaps the recession of 2001 was an outlier, caused by the bursting of the dotcom bubble’s sky-high P/E multiples. The 2008 recession was even more unusual — with unprecedented leverage in real estate, banking and in corporations.”
Kass’s points are well taken, but I suspect the error is about something else. Structural changes at Wall Street firms are just as likely to be the cause. Research analysts used to work for trading and asset management divisions of big Wall Street banks. Since the 1990s, they have mostly migrated to underwriting. That’s where all the money is made.
This change has changed the job of the analyst. They do far less critical analysis and far more “cheerleading.” Robert Powell, editor of Retirement Weekly, confirms it: Regarding the stocks that make up the S&P1500, Powell noted that not a single one has a Wall Street consensus “sell” rating on it. This is pretty damning proof that forecasting errors may be because of inherent structural bias.
Given all that, what might the volatilitymean for markets?
I think about day-to-day market action as a conversation between investors holding different expectations about the future. Their range of opinions affects their outlooks about earnings and prices. Some believe the recent deceleration is only temporary and the economy is poised to take off again. Some investors believe we will avoid a recession, but only just barely. More bearish traders believe a regular cyclical recession is inevitable. The most negative outlook is for a nasty recession, with rising unemployment, more foreclosures and another leg down in housing.
On any single day, market action is just noise. Over time, as more and more data accumulate, this “conversation” becomes more intense. The markets eventually gather enough information to determine who is correct, and prices adjust accordingly.
The Street’s earnings forecast for the S&P 500-stock index is about $95 for 2011, and about $112 for 2012. If the bulls are right and the economy rebounds, stocks could be undervalued by 30 to 40 percent. If the bears are right, earnings estimates might too high by as much as 30 to 40 percent, and a recession-driven earnings contraction means lower equity prices.
My views are in between. At the least, I expect more slowing in the economy, reflected in weaker earnings and lower prices. However, I do not have enough information to see around the corner to how severe or mild the slowdown will be.
As we have suggested before, you should take a proactive approach that recognizes these various possibilities and plan accordingly. That means holding a decent amount of cash and bonds (I am at 50 percent) so you can ride out the downturn and have some buying power when things get cheap.
Ritholtz is chief executive of FusionIQ, a quantitative research firm. He is the author of “Bailout Nation” and runs a finance blog, The Big Picture.
The Post Most: BusinessMost-viewed stories, videos and galleries int he past two hours
Watchlist
World Markets from
Other Market Data from
Key Rates from
Loading...
Comments
The Washington Post commenting system will be disabled for several hours while system upgrades are made. User will be unable to leave comments during this time.
If you have any problems accessing Washington Post content during this time, please email our Interactivity department at comments@washpost.com.