The Problem With Analysts Forecasts

We can’t predict the future. If we could, fortune tellers would all win the lottery. They don’t, we can’t, and we aren’t going to try. However, this doesn’t stop the annual parade of Wall Street analysts from putting out forecasts on the S&P 500.

The Problem With Forecasts

In reality, all we can do is analyze what has happened in the past, weed through the noise of the present and try to discern the possible outcomes of the future.

The biggest single problem with Wall Street, both today and in the past, 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.

Ed Yardeni annually publishes the two following charts which also show analysts are always overly optimistic in their estimates.

analysts forecasts, #MacroView: The Problem With Analysts Forecasts

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.

Furthermore, the reason that earnings only grew at 6% over the last 70-years is that the companies that make up the stock market are a reflection of real economic growth. Stocks cannot outgrow the economy in the long term. 

“Since 1947, earnings per share have grown at 6.21% annually, while the economy expanded by 6.47% annually. That close relationship in growth rates should be logical, particularly given the significant role that consumer spending has in the GDP equation.”

analysts forecasts, #MacroView: The Problem With Analysts Forecasts

We can see this correlation even better when looking at the corporate profits versus stocks.

analysts forecasts, #MacroView: The Problem With Analysts Forecasts

 

Conflicted Forecasters

The McKenzie study noted that on average “analysts’ forecasts have been almost 100% too high” and this leads investors into making much more aggressive bets in the financial markets. Wall Street is a group of highly conflicted marketing and PR firms. Companies hire Wall Street to “market” for them so that their stock prices will rise and with executive pay tied to stock-based compensation you can understand their desire.

However, if analysts are bearish on the companies they cover – their access to information to the company they cover is cut off. This reduces fees from the company to the Wall Street firm hurting their revenue. Furthermore, Wall Street has to have a customer to sell their products to – that would be you.

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