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Study: Stock Analysts Overoptimistic, Slow to New Trends

Friday, 04 Jun 2010 11:55 AM

 

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The story of corporate America's comeback has a nice ring to it. That is, if it can last.

Wall Street stock analysts think it will. They're almost chirpy the way they keep pumping up their earnings estimates and dismissing the stock market's volatility, the financial crisis in Europe and risks to the U.S. economic recovery.

But their track record shouldn't give anyone confidence. History shows analysts rarely get it right when it comes to predicting how much companies will earn.

"Analysts almost never see a recession coming," says Ed Yardeni, who runs his own investment and economics consulting firm.

Yardeni says the problem is that analysts get most their information from the companies they cover. Corporate managers have every incentive to stay positive for as long as they can.

Analysts then use what they're told to advise investors on whether to buy or sell stocks, and forecast corporate earnings, which are closely followed by investors to see if companies meet, beat or miss analysts' estimates.

New research from the consulting firm McKinsey & Co. found analysts tend to be overoptimistic, slow to revise their forecasts to reflect new economic conditions and prone to making inaccurate predictions especially when economic growth declines.

Looking at data from the last 25 years, McKinsey found analysts have estimated annual earnings growth to be about 10 percent to 12 percent for Standard and Poor's 500 companies, but actual growth has only been about 6 percent.

Analysts only seem to hit the mark with their estimates in the strongest economic times. That happened during 2003 to 2006, when the economy was raging and the stock market set off on a record-setting run.

Yardeni isn't betting on a return of the recession, but he's increasingly concerned about the state of the global economy. "Every day for the last month I've been losing confidence," says the one-time bull.

He worries that the European debt crisis could be a catalyst for a return of financial market contagion. If that causes credit markets to freeze up like they did in the fall of 2008, Yardeni thinks that could hit U.S. companies hard because it would constrain their ability to borrow.

On top of that, the strong dollar could hurt U.S. exports by making American goods more expensive abroad. U.S. consumers are still watching their spending amid high unemployment rates and a weak housing market.

Analysts seem willing to look beyond those headwinds. Even as investors bailed out of the stock market at a ferocious pace in May, analysts reacted in the opposite way. Earnings estimates rose by 0.7 percent last month for 1,647 public companies tracked by Thomson Reuters. Stock prices for that sample dropped by 8 percent over the same time period.

It's unusual for analysts to keep raising their earnings estimates. Typically forecasts start high at the beginning of the year, and are reduced and refined as analysts get more clarity on current conditions.

Analysts generally believe the earnings boom will continue. However, many of them are likely taking their cues from upbeat corporate leaders, who say problems abroad aren't hurting their businesses. As Yardeni and other cautious observers say, it's hardly clear that booming growth will go on.

During the first quarter, corporate profits as measured by the government rose 31 percent over the same period a year ago, the biggest gain since 1984, according to Barclays Capital.

That jump was fed in part by improved productivity, but that can't last forever because companies will struggle to squeeze more work out of their lean staffs. Ultra-low interest rates have also bolstered earnings by making borrowing cheap. That benefit will eventually run out as rates begin to rise.

Maybe the good times will go on, but analysts will likely be the last to acknowledge if they don't.

"There are reasons for analysts to be optimistic," says Kent Womack, a finance professor at Dartmouth College's business school who has studied stock analysts' work extensively. "They haven't seemed to figure out why they should be skeptical."

In the meantime, the rest of us had better be careful.

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