Fundamentally Speaking: Earnings Optimism Explodes

As markets surge to record highs, analysts are rushing to ratchet up earnings estimates as optimism explodes.

“The first quarter of 2021 marked the largest increase in the bottom-up EPS estimate during a quarter since FactSet began tracking the quarterly bottom-up EPS estimate in Q2 2002. The previous record was 5.4%, which occurred in Q1 2018 after tax reform was passed.” – FactSet

Earnings Optimism Explodes, #Fundamentally Speaking: Earnings Optimism Explodes

Of course, with market’s at record highs, Wall Street needs drastically higher estimates to rationalize bullish allocations. However, before we get into the risks of forward expectations, let’s review what happened.

A Disappointing Past

Through the end of 2020, quarterly operating earnings increased $0.01 to $38.19 from $38.18 at the end of 2019.

You read that correctly.

Quarterly operating earnings, which are mostly useless as companies exclude all the “bad stuff” and fudge the restincreased by just $0.01 while markets exploded 16.28% in 2020.

It is far worse when looking at “real” reported earnings, which declined -11.4% from $35.53 to $31.45.

However, the good news is these are very sharp recoveries from the Q1-2020 lows of $19.50 and $11.98 per share, respectively, as the economy reopened.

Earnings Optimism Explodes, #Fundamentally Speaking: Earnings Optimism Explodes

With markets at record highs, have investors “priced in” the most optimistic outlooks for the economy and earnings growth?

Earnings Growth Not As Strong As Advertised

Analysts always over-estimate earnings by about 33% on average. As discussed in “The Problem With Analyst’s Forecasts:”

“The biggest single problem with Wall Street is the consistent disregard of the possibilities for unexpected, random events. In a 2010 study, by the McKinsey Group, they found that analysts have been persistently overly optimistic for 25 years. During the 25-year time frame, Wall Street analysts pegged earnings growth at 10-12% a year when in reality earnings grew at 6% which, as we have discussed in the past, is the growth rate of the economy.”

Earnings Optimism Explodes, #Fundamentally Speaking: Earnings Optimism Explodes

“This is why using forward earnings estimates as a valuation metric is so incredibly flawed – as the estimates are always overly optimistic roughly 33% on average.”

Such is incredibly important when you begin to think about “valuation” and forward returns. Take a look at the chart below.

In January of 2020, S&P put out their first earnings estimates through the end of 2021. At that time, they estimated the S&P 500 index would print “reported” earnings of $171/share in 2021. As of the latest report, expectations for 2021 are now $13 lower at $158/share. Yet, investors are paying 20.4x earnings today for what they thought would be 18.8x earnings.

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