Some 15 years ago, my partners and I commissioned a research from a quant supplier to measure the accuracy of street research. We were shown that aggregate bottom-up research had to be discounted by 15% until after Q1 of any given year. For example, if in September 2000 S&P 500 Index EPS were forecast to reach $100 in 2001, it was more prudent to use $85 in our market valuation based on forward earnings. After Q1 2001 results, analysts gradually nudged down their estimates so that by mid-year they provided a more accurate picture. The only exceptions to this “rule” were in certain recovery years after a recession when analysts, having been badly burned the previous year, used their more prudent calculator and generally undershooted.
Nearly 10 years ago, McKinsey % Co. did its own research on analysts estimates finding that
analysts were typically overoptimistic, slow to revise their forecasts to reflect new economic conditions, and prone to making increasingly inaccurate forecasts when economic growth declined.
McKinsey recently completed an update. Their findings will not comfort you:
analysts have been persistently overoptimistic for the past 25 years, with estimates ranging from 10 to 12 percent a year, compared with actual earnings growth of 6 percent. Over this time frame, actual earnings growth
surpassed forecasts in only two instances, both during the earnings recovery following a recession. On average, analysts’ forecasts have been almost 100 percent too high.
Company executives have learned the market impact of positive earnings surprises and revisions and have developed a collective habit of “underpromising” to “overdeliver”. Them, why are sell side analysts forecasts still too optimistic? Maybe, since, like most everybody, they know the game executives play they try to compensate for it. But even corporate execs can be wrong, especially in tougher economies.
Market prognosis based on forward earnings should always be careful. It is best, in most instances (though not in 2009), to value equities using trailing earnings, unless forward earnings are sufficiently discounted.