Charter Trust Company
By Mark Ungewitter
October 7th, 2013
There’s an old saying on Wall Street: “The market never discounts the same thing twice.” With government-shutdown and debt-ceiling theatrics becoming an annual ritual, perhaps there’s something else behind the recent loss of market momentum.
The main thing keeping me up at night is corporate profitability. Third quarter earnings will soon dominate the financial news. Operating earnings have been sluggish over the past two years, rising only 8% since Q3 2011 versus a stock-market run-up of nearly 50%. P/E multiples, in other words, have been powered much more by “P” than “E.”
Wall Street is expecting all of this to change very soon. Analysts are projecting that earnings are now entering a sharp acceleration phase. The table below details projections from Standard & Poors Corporation out to year-end 2014. This trajectory is representative of the entire Street. (The analyst community is projecting an average of $120 at year-end 2014 according to Thomson Reuters I/B/E/S.).
But what if Wall Street is wrong? What if the earnings “hockey stick” fails to materialize? The chart below, from Bianco Research L.L.C., shows that Wall Street analysts have a lousy track record, typically overestimating next year’s earnings by 10%-15%. While this study is somewhat dated, its message is not. Wall Street is routinely over-optimistic. And while optimism is an admirable trait, skepticism is the preferred attitude in matters financial.
A skeptical observer, for example, might note that a normal forecasting error of 10%-15% would leave earnings essentially flat over the next twelve months. This would not bode well for a market which, over the past two years, has shrugged off an absence of earnings growth. A successful “assault on $100,” on the other hand, might justify today’s extended P/E multiples, propelling the S&P 500 up and out its recent slump. In either case, Q3 is pivotal. So, let’s keep a close watch on corporate earnings as we enter October.
With all eyes on Washington, the real showdown is likely to occur somewhere else.