Forecasting the forecasters - plus the best investing blogs and podcasts this week
Earnings season is well under way in the US and already there’s a sense that things have gone better than expected. While the number and magnitude of earnings ‘beats’ looks set to come in below the five-year average, earnings growth is up across the S&P 500, driven very much by bumper profits in the energy sector.
This comes as debate rages over whether the US is already in, or heading for, a recession. The National Bureau of Economic Research (NBER) is the authority on this, but their model isn’t very user-friendly. Sure, a few months of GDP contraction certainly comes into it, but there are other factors at play too. So while pundits are desperate for a definitive answer, it turns out it just ain’t that simple.
Getting back to earnings trends and forecasts, the US regime of calendar-quarter reporting makes it easy for data firms to track movements in the analyst consensus across the whole market. This gives them a good picture of the outlook for corporate health that you don’t really get in the same way in the UK and elsewhere.
For instance, FactSet report that in July, third-quarter EPS estimates were lowered by a larger margin than usual - a sign that analysts are starting to price-in the gloomy macro outlook.
For those not used to the quarterly reporting regime, a quick pointer: in the first month of every quarter analysts tend to reduce their earnings estimates. Over the past 10 years (40 quarters) the decline has averaged about 1.8%, according to FactSet. In July it was much wider, at 2.5%.
Source: FactSet
Not only that, but earnings estimates in the States have now been lowered for the whole of 2022 and 2023. Recession or not, it’s clear that analysts are expecting a bumpy ride. You can read that analysis here.
In some ways, these forecast adjustments come as a relief. For a while now there have been murmurings that analysts just weren’t getting it; that the supposed experts weren’t reining in their forecasts by anywhere near enough to account for rising inflation, rate hikes, recession, war and pandemics. Generally, there’s been a sense of too much optimism and not enough reality in earnings estimates.
The same goes for the UK. This quote in the FT this week sums it up:
“We’re going to be seeing earnings downgrades, no doubt about that,” said Neil Birrell, chief investment officer at asset manager Premier Milton Investors. The consensus of analysts’ estimates, Birrell added, “looks like they are in cloud cuckoo land.”
Are analysts in cloud cuckoo land? Maybe. But perhaps another explanation is that after 12 years of predominantly upbeat economic and market conditions, analysts are simply out of practice with recessions.
Source: Vanguard
As this chart from Vanguard shows, you really need to go back to the early 2000s to have lived through a full economic cycle: from economic boom to sustained contraction and the impact it had on markets. Perhaps it’s not unreasonable to think that a substantial number of analysts either weren’t there, have forgotten, or are suffering from recency bias.
While that might sound unlikely, studies have found that analyst forecasts are influenced by macro conditions - but not necessarily in the way that you’d think.
A 2014 investigation by Clement and Law examined whether the earnings forecasts of sell-side analysts were influenced by the prevailing economic conditions when they were hired or given a major promotion.
They found that analysts who start out in a recession tend to be more guarded in their forecasts. In the words of the researchers, they are more pessimistic, less likely to be leaders, deviate less from the consensus, and more likely to issue negative bold revisions (and less likely to issue positive ones).
While the study didn’t outright say that pessimistic analysts make superior forecasts, it did find that they often end up working for more prestigious brokerages.
If you wanted to push this theory a little further, you could also argue that the last recession - the epicentre of which was banking - led to mass-firings and hiring freezes across the industry. So there’s arguably a lost generation of analysts that weren’t around to see how that recession impacted on corporate earnings, and that’s showing up today.
Regardless of where the truth lies in all this - whether analysts are getting their forecast right or not - companies are facing conditions not seen for many years, but are nonetheless part of the economic cycle. This whole experience will give us all a reminder that it’s not all bull markets and positive earnings surprises; that contractions happen too, and they can be brutal.
Six posts from the past week
Quality Small Caps Podcast with Paul Scott - Episode 5
It would be quite easy to listen to Paul ruminating on markets and small-cap shares all day long. In a year that’s been tough at the smaller end of the market, the big question for investors is whether we’re at a turning point. In his latest podcast roundup, Paul chats about signs of an improving outlook, upbeat company reports, access to broker research, earnings pressure and improved valuations, stop losses and buybacks. On top of all that he picks up on a host of highlights from companies over the past week.
The Irrelevant Investor - Things Are Clear as Mud
The market rally in July has left us with more questions than answers when it comes to figuring out what’s going on in the mind of the market at the moment. If you haven’t read anything else on this subject then this article from Michael Batnick is what you need. Quite rightly, he doesn’t profess to have the answers, but he does a neat job of setting out all the competing influences right now.
Stock market swings this year have triggered fevered discussion about valuations, much of which is mere speculation. What’s needed at a time like this is a solid measure with which you can compare current valuations with long-term trends. And that’s where the CAPE ratio - or Shiller P/E - comes in. This article from Monevator gives you everything you need to know about the CAPE so you can draw your own conclusions about where we’re at.
Investor Amnesia - The Unknown History of U.S. Trade Surveillance
Jamie Catherwood’s Investor Amnesia blog knits history and finance to find meaning in markets, and this guest post from Miles Kellerman is worth a read. It explores the long-running power struggle between America’s financial regulator, the SEC, and the country’s biggest stock exchanges over who should keep tabs on trading in order to detect fraud and other risks. Lobbying by exchanges has kept that remit with them for the most part, but some evidence suggests that hasn’t been the best outcome.
The MoneyWeek Podcast - 17 years of change
John Stepek is stepping down as editor of MoneyWeek after 17 years and in this week’s podcast he and Merryn Somerset Webb look back at how the financial landscape has changed in that time. Back in 2005, oil was hitting new highs of $60 per barrel and people were grumbling about house prices. Then came the financial crisis and a prolonged spell of ultra low interest rates… and still the housing market presents some of the biggest headaches.
Klement on Investing - Hitchhiker’s Guide to Investment Research, Part 4: Trust but falsify and Part 5: The Two Razors
Last week I covered the first three instalments in Joachim Klement’s summer series of philosophical thoughts on investing. In true Hitchhiker’s style, the fourth and fifth parts of the trilogy were out this week. In them he covers the science of finance and the two principles that guide his approach to research.
Have a great weekend!
Ben
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