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The Earnings Revisions Circus

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Watch analysts scramble to adjust all things upward.

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In retrospect, I believe history will show that one of the more interesting phenomena associated with the 2008-2009 financial crisis and the subsequent recovery, will be the dramatic breakdown of valuation discipline on the part of the Wall Street sell-side analyst community. This phenomena, that we're currently witness to, may be the subject of interesting future academic studies.

Analysts that had been far too late in identifying potential problems in the economy, their sectors and their companies, were evidently caught by surprise by events in late 2008 and early 2009. The future uncertainty emanating from the financial crisis certainly led to complications in EPS estimation.

However, I believe history will show that it was, above all, the collapse of market prices that lead to a panic in the analyst community. This panic was accompanied by a concomitant loss of analytical rigor in the estimation of EPS, and above all, in the setting of price targets by analysts. Analysts essentially let collapsing market prices determine their price targets rather than setting price targets based on a disciplined valuation methodology.

The ongoing correction of this irrational overreaction by the analyst community has huge implications for the market in the coming months.

Earnings Revisions

Bespoke Investment Group recently published an analysis on earnings revisions that's worthy of perusal.

The data gathered and elegantly presented by Bespoke empirically confirms something that I've been emphasizing in my writings: In late 2008 and early 2009, many analysts got caught up in the atmosphere of doom and gloom, and overreacted - overshooting in their downwards revisions of earnings. Many of these same analysts are now scrambling to revise their EPS numbers upwards.

Earnings revisions are still net negative by a slight margin (-5.5%). However, the turn in the second derivative of earnings revisions (which plunged below -60% in November) has been spectacular. You can especially see this on the graphs on pages 3-4 of the Bespoke analysis. Indeed, the earnings-revisions indicator has improved so much that it's now comfortably above levels prior to the Lehman crisis.

Indeed, statistical analysis suggests that if the market were to follow the path of earnings revisions -- and market returns have historically correlated quite closely with earnings revisions -- the S&P 500 would currently be well above 1,200.

Notwithstanding the above observation, I find it far more interesting to look at the revisions statistics by sector and by group. This sort of segmented approach leads to mostly bullish investment implications. Specifically, a segmented analysis shows that the most economically relevant and sensitive sectors are showing the most positive revisions momentum

For example:

1. Personal consumption represents about 70% of US GDP. The consumer discretionary sector as a whole (+29.3%), including consumer durables (+2.9) are exhibiting strong upwards earnings revisions.

2. The US is primarily a service economy (68% of GDP), and the vast majority of that is focused on consumer services. So it's good to see consumer services as one of the groups with the highest revision ratios (+34.9%).
No positions in stocks mentioned.
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