The Usefulness of Forward Earnings

Regular readers of "A Dash" know that we believe in looking forward to predict and looking back when writing about history.  It is a constant source of amazement to us that this viewpoint is so unpopular in Wall Street Research.

Those analyzing earnings love talking about the certainty of trailing earnings.  They know exactly what the final reports were.  These market strategists must then decide how to predict the future from this past record.  For those who have made up their minds before starting their research, this provides the freedom to say whatever they want.  They can assert that the analysts covering firms are too optimistic, or too pessimistic.  They can claim that there is an imminent housing-induced recession, or they can claim that the Fed will cut rates to spark a new rally.

The question is whether this freedom to make these guesses about the future — and that is what they are — really adds any value for those of us who are consumers of their work, whether we are traders or long-term investors.

An alternative approach is to take the forward earnings projections of the analyst community as a starting point.  You have hundreds of experts, all trying to do their jobs.  Like all good fund managers, we listen to the conference calls or read transcripts on the companies we follow. We frequently disagree with analyst conclusions about the future of a specific company’s stock price.  The analyst work is still a useful place to begin, if only because they spend all of their time studying these companies.

If one wishes to question their work, take a look at their earnings models.  Look for questionable assumptions or faulty methods.  Be willing to do some serious homework.

But let us ask how the analyst community does in the aggregate.  Those who think that looking backward is a good approach might be enlightened by the chart below.  [click on chart to enlarge.]


The chart is on a log scale, so that a doubling of earnings looks the same in various time periods.  The shaded areas show recessions as identified by the official body for these determinations, the National Bureau of Economic Research (NBER).

The most striking feature of the chart is that the forward earnings estimates, from the excellent data compiled by Thomson Financial, are contemporaneous.  The recession  periods were determined later — sometimes much later — when actual economic figures including final revisions were reported.

Three conclusions leap out.

1. A decline in forward earnings, while generating some nervous "false positives", provides a pretty good indication of a possible recession.
2. Forward earnings often find a point of "looking through" the current economic situation and providing a forecast.  That is, after all, what we expect of analysts who are studying companies and looking ahead.
3. The earnings recovery from recessions has been excellent for thirty years.

The problem with backward-looking methods is that they fail to miss turning points.  Many analysts have predicted for months, or even years, that these estimates should be falling.  These analysts have been wrong about earnings and wrong about the market.  They would have done better to look at the Thomson data rather than looking in the rear-view mirror or their own hypothetical scenarios.

We shall continue this series by evaluating whether forward earnings projections have a bias, either upward or downward.