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Why You Should Ignore Wall Street's Earnings Estimates


A rising target price makes little sense for a flat-earning S&P 500.

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 (NYSE: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.
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