Why You Should Ignore Wall Street's Earnings Estimates

If you have kids, you may remember the Sesame Street segment "Which One of These Things Does Not Belong Here?"

You may also remember the tune that went along with it: "One of these things is not like the others, one of these things just doesn't belong, can you tell which thing is not like the others, by the time I finish my song?"

We are about to play a similar game.

S&P Price Target Raised, Earnings Remain Flat

Over the weekend, Bloomberg reported:

"The same analysts who lowered second-quarter profit growth predictions to almost nothing in 2013 are raising (S&P) price forecasts (NYSEARCA:SPY) . Standard and Poor's 500 Index earnings rose 1.8% last quarter, down from a projection of 8.7% six months ago, according to more than 11,000 analyst estimates. The US equity gauge will increase 8.9% to a record 1778, should their (updated) forecasts prove accurate."

Their reasons for upping their S&P target price (NYSEARCA:SSO) range from "Investor confidence is growing" to "the economy is gaining sustainable momentum." But if that's really the case, then why wouldn't you also expect earnings estimates to rise instead of their recent declines?

How Bad is the Earnings Guidance for the Second Quarter?

Business Insider notes, "The percentage of companies issuing negative EPS guidance is 81%; if this is the final percentage for the quarter, it will mark the highest percentage of companies issuing negative EPS guidance for a quarter."

So, let me get this straight: This is the worst quarter ever for earnings guidance, but Wall Street analysts still continue to raise their S&P price targets?! Looking at the recent trend of earnings estimates, one must really question Wall Street's ability (or CEOs' abilities, for that matter) to even predict earnings in the first place (more on that below).

On June 25, I looked at the very long-term trend of earnings growth and wrote, "Throughout 142 years of history, investors should expect earnings to decline 10% year over year on average once every five quarters, and an earnings decline over 20% should be expected 10% of the time, or once out of every ten quarters (2.5 years)."

It has now been four years since we have seen any significant negative earnings growth. In that analysis, it was also very clear that earnings do not grow positively into perpetuity, and after four years since any significant decline, the business cycle may be ready to again take hold.

Rising Prices on Lowered Earnings

In an example from the first major S&P component to report, Alcoa's ( AA ) Q2 adjusted earnings of $0.07 "beat" its estimate of $0.06.

Not mentioned by the news sources though is that Alcoa's Q2 earnings estimate was way up at $0.60 in early 2011 and at $0.28 last year. The company has dropped its earnings estimate by over 90% since it started giving guidance. With estimates that far off, it is amazing we put any trust in estimates in the first place.

When prices rise (NYSEARCA:IWM) and earnings do not, this means one thing: Investors are paying more for a product that is delivering less. But starting out with extremely high estimates that are then dropped through time is nothing new.

The charts below from Standard and Poor's show this trend for the S&P 500 (INDEXSP:.INX) over the last two years. A look back to the '90s shows this practice is actually the norm.

Reality shows that S&P earnings estimates have been declining since 2011, meaning that prices (along with P/E ratios) are rising (NYSEARCA:DVY) for reasons beyond underlying fundamental expectations. This also means that investors have been paying more and getting less during that time.

Whatever the reasons, without earnings to eventually accompany, share price (NYSEARCA:SPXS) growth is likely unsustainable over the longer run.

Figure 1: Can You Find the Outlier?

The first two charts above show how analysts have been lowering earnings guidance for well over two years now. Estimates were lowered around 10% by the third quarter of 2012, and down over 15% to just $97 by the time 2012 was completed (not shown). This resulted in a P/E ratio (NYSEARCA:UPRO) that jumped from 12x to 15x by Dec 2012.

Again, the latest earnings estimates for 2013 have been significantly lowered through time, also down around 10% (so far) and also resulting in a significantly higher real P/E ratio, currently over 16x (NYSEARCA:IVV). If earnings continue to decline, this just means the P/E will go higher.

One of These Things Does Not Belong Here

Looking at the final chart above of 2014 earnings estimates, we see a chart that clearly look different. For the first three months that 2014 has been estimated, earnings are expected to be higher and rising, as businesses are still focusing on 2013.

The same thing occurred with 2012's and 2013's earnings estimates that were also initially expected to rise. That is, until reality set in, CEOs started to get visibility, actual earnings started to disappoint, and future estimates were finally lowered.

2013's decline continues today as the 2013 chart in Figure 1 above shows. If 2012 is any lesson, it would not be surprising to see 2013 earnings follow 2012's footprint and continue to be ratcheted down through December.

For now, 2014's estimates remain the odd chart out -- that is, until CEOs start to actually look at the significantly higher 2014 earnings targets and also start ratcheting them down.

Given Wall Street's horrid history of earnings estimates, we should expect 2014 earnings estimates to eventually be pulled back as 2013 estimates continue to disappoint.

Editor's note: This story by Chad Karnes originally appeared on .

To read more from ETFguide, see:

Why Are TIPS Losing Value?

It's Official, Gold Was a Bubble

The Three Biggest Investment Trends of 2013

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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