Earnings Expectations Are Grossly Optimistic

As we enter into the end of the year, the vast majority of analysts have already come out with bullish forecasts for the S&P 500 going into 2015. The primary driver behind these optimistic forecasts is simply stronger economic growth will lead to higher corporate earnings which will justify higher asset prices. Fair enough.

The problem is that the expectations of earnings growth in the future is currently at levels that do not generally exist outside of a recessionary recovery. The chart below shows the actual and estimated annual percentage change in earnings for the S&P 500 going back to 2000.  (Note: The percentage changes from the financial crisis lows were so great that I had to cap them and label them accordingly.)

There are several important points to consider with respect to this data.

1) Following recessions earnings changes are the greatest as the annual EPS change from lower levels yields significantly higher percentage changes.  (i.e., Increasing EPS by $10 yields a 100% growth rate from $10 to $20 versus just 10% when growing from $100 to $110)

2) Earnings growth has been highly supported in recent years by not only massive share buybacks, cost cutting and other accounting mechanization but also from federal reserve interventions. That surge in liquidity increased share values significantly which allowed for high levels of stock based M&A that supported earnings growth. Notice that “Operation Twist” EPS growth slowed significantly but exploded once QE-3 was introduced back into the system. Also, the growth rate of EPS has begun to slow once the Federal Reserve began to taper, and how now eliminated, their bond purchasing activities.

3) The current estimates for EPS growth going into 2016 are currently at levels that exceed historical norms.

With deflation and weak economic growth plaguing every single country outside of the u.s., it is highly likely that estimates of stronger economic growth will be disappointed. Eventually, market participants will realize that current valuations far exceed economic realities and a reversion to norms will occur. That is just a function of how markets work as excesses are eliminated.  The challenge for investors is not only realizing that this will eventually be the case, but also the capability to manage portfolio risk accordingly.