Are Wall Street Earnings Estimates Good Barometers of the Future?

Individuals, institutional investors and the financial press often make much of earnings estimates from the big Wall Street firms.  Are these estimates good indicators of the future or can they be much ado about nothing?

A McKinsey study that was done over a decade ago on the accuracy of earnings estimates was updated in the Spring of 2010 (see Equity Analysts: Still Too Bullish or refer to the link on our Idea Flow page).

Why do we start our Blog today on a report that was done years ago based on some decade old premises?  Because, like the original report, the new data produced results that are surprising to many.

Before I get to the punch line, twice each year (Spring and Fall) I get the privilege of conducting a series of classes for a Harvard-sponsored investment club, Smart Woman Securities (SWS), that is primarily focused on educating young women about the basics of investment management.  SWS was founded approximately 9 years ago at Harvard and has grown with the support of individuals such as Warren Buffet to establish itself at many Ivy League campuses.  The subject of my first talk this semester was on thoughts to consider when formulating an investment plan and the basics of stocks, bonds and money market instruments.  This coming Thursday, I will speak to the group in more detail about the equity market and discuss some of the factors that I feel drive the overall market and individual security prices.  For the past few years, I have been showing the slide below, which was based on the original McKinsey study and data compiled from Thomson Reuters.

The combination of my preparation for this week’s class and an article in the Sunday NY Times by Paul Lim (more on this below), made me finally post this Blog, which I had drafted at the beginning of the year.

What the chart above highlights, and the McKinsey study has twice observed, is that Wall Street analysts can be herd animals and get somewhat anchored on a trend.  They tend to be late to revise earnings up, to be late to revise earnings down and to move in groups.  Beyond anchoring, I believe this is also due to pain avoidance.  It is painful to be right early on Wall Street.  If an analyst is out in front and seems to be wrong for a quarter or two, the pain in terms of job security and reduced bonus potential might be high.

For those of you who wish to dive deeper into the current numbers, consider a look at earnings estimates that were just put out by Ed Yardeni and Job Abbott.

Yardeni – Earnings, Revenues & Valuation S&P 500/400/600

With all of this, I am not suggesting that we should not follow useful information being published by top analysts.  I am just cautioning that we should not get overly anchored on estimates of the future.  Many factors beyond Wall Street estimates affect the market and the prices of individual securities.

This brings me to the article by Paul Lim in the NY Times Sunday Business section titled “Fundamentally”.  In Lim’s article, he mentions research done by Doug Ramsey, Chief Investment Officer of the Leuthold Group.  For those of you who do not know Leuthold, it is a well respected, independent institutional research firm that is known for thought leadership.

According to Lim, Ramsey’s research looked at stock market performance going back to 1938, and discovered that little correlation exists between earnings growth and stock price movements in any one year.  In the article, Lim mentions that Ramsey discovered that in the 16 best years for stocks, eight actually coincided with declines in corporate earnings.  And profits rose in 13 of the 16 worst years for stocks.

I do not feel that this work should be taken to suggest that earnings are not important to stock market performance.  I think they are an important factor.  As does the McKinsey paper, the research by Ramsey just highlights that we should not be as focused as I think we often are on current earnings or earnings estimates as predictors of future performance.

Versus trying to track or watch earnings estimates, or predict year to year market movements, try to be focused on sticking to the long-term factors important to achieving your plan.

As I speak to the SWS group this week, I will remind them of my strong feelings about investing to meet personal objectives versus making it a competition against others or the market.  Investing should be about doing what is proper over the long term for you, not about watching the market day to day, or estimate to estimate.

So, when you turn on the financial press in the morning or get the latest research from your favorite firm, try to take it with a grain of salt.  What will the future bring?  I certainly do not know.  What I do feel is that we all need to try to avoid the day to day market swings and the emotion from future estimates of the market.  If we can, and it is not easy, I am confident that we will be better investors and fiduciaries of our plans.

 

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