Insight: Equity analysts behind the curve...again - MAARS News

By Ben Hirschler and Scott Barber/reuters.com

(Reuters) ? Equity analysts seem to have been caught out once again by a tectonic shift in economic outlook, highlighting potential pitfalls in earnings models devised by highly-paid professionals on Wall Street and in the City of London.

photo: hken.ibtimes.com

While businesses and households on both sides of the Atlantic have been sending a clear message for months that an already weak economy is slowing sharply, forecasts for future company earnings have barely budged.

Consensus forecasts from Thomson Reuters still point to 15.3 percent earnings growth for U.S. companies over the next 12 months and 11.6 percent for Europe.

Both numbers now seem destined to fall. If they do, equities might turn out not to be as cheap as they appear.

Unexpectedly sturdy first-half profits have played a pivotal role in propping up hopes until recently. But, as investment houses routinely warn, past performance is no guarantee of future results and many investors are now wondering just when those earnings will start to slide.

Today?s picture of earnings forecasts is worryingly similar to that in 2008.

Then it took the collapse of Lehman Brothers to finally prompt analysts to cut forecasts on both sides of the Atlantic, despite the earlier crisis at Bear Stearns and strong flashing lights from the real economy.

This year, just as in 2008, both the U.S. Institute for Supply Management index and the euro zone Purchasing Managers Index ? two measures of real economic activity ? have turned sharply lower far ahead of any move in earnings forecasts.

TELL ME A STORY

The rout in global stock markets, driven by fears over growth, shows investors certainly have little faith in corporate profits in the wake of Standard & Poor?s decision to strip the United States of its top-notch credit rating and Europe?s continuing debt crisis.

So why have equity analysts apparently not factored these big macro shifts into earnings forecasts?

One reason is that they are emotional as well as rational beings, according to David Tuckett of University College London, who has conducted a psychoanalytical study of markets after interviewing fund managers controlling over $50 billion.

?Financial markets are markets in stories, and financial analysts are strongly influenced by the mood context of the moment,? he said.

?At the same time, they tend to simply extrapolate from what has happened forward and they tend to do it as a group. There?s a lot to be lost from standing out from the crowd ? they want to stand out a bit but not too much.?

Tuckett describes the phenomenon as ?groupfeel.?

?Groupfeel is the same as groupthink, except it is based on wanting to feel like everyone else rather than wanting to feel dangerously out of the crowd. That naturally makes it difficult for them to change quickly, unless everybody else is changing.?

Some ?top-down? strategists are now moving on earnings. Credit Suisse on Friday hacked backed its 2011 forecast for euro zone earnings growth to 7 percent from 12 percent and cut U.S. estimates to 12 percent from 14 percent.

?Bottom-up? analysts, looking at individual companies, are slower. Being a good analyst means being close to the company you follow and those companies will tend to maintain rosy outlooks for as long as possible.

Many securities houses are also slow to feed big, non-company specific macro factors into their models. Those that do may therefore have an edge.

Winners in predicting the post-Lehman earnings landscape in the United States and Europe included Bank of America Merrill Lynch, Goldman Sachs, Credit Suisse and UBS, according to Starmine. link.reuters.com/jaf23s

POLITICAL DILEMMA

Daniel Beunza, a lecturer in management at the London School of Economics, says the political uncertainty at the heart of the current crisis is particularly hard for equity analysts to model ? and he points out we have been before.

Beunza has a paper accepted for publication in the journal Economy and Society analyzing one specific example of politics confounding the smartest analysts, when Europe?s competition head Mario Monti blocked General Electric?s takeover of Honeywell International in 2001.

In a similar way, oil company analysts continually underestimated the political fallout of BP?s Gulf of Mexico oil spill in 2010.

?Typically, where market participants get it wrong is when they have to price in political factors,? Beunza said. ?The whole sovereign debt crisis requires a knowledge of politics that, for most part, they don?t have.?

Economists polled by Reuters now believe the chances of another U.S. recession are rising and Europe?s recovery is also at risk, although they are still clinging to hopes of better times ahead.

But their numbers, too, probably need to be taken with a pinch of salt. An analysis of earlier polls found economists were too optimistic about 20 out of 27 major monthly indicators from April and May in the United States, euro zone and Britain.

Source: http://news.maars.net/blog/2011/08/10/insight-equity-analysts-behind-the-curve-again/

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