Are Earnings Cyclical? – Grantham Calls Margins ‘Freakishly High’ That Doll Says Are Here to Stay

U.S. companies are the most profitable in more than 40 years, and some of the best-known stock pickers are divided over how long that will last. Bob Doll, chief equity strategist at BlackRock Inc. (BLK), said low labor costs and cost-saving technology will allow companies to keep up their profitability. Jeremy Grantham, chief investment strategist of Boston-based Grantham, Mayo, Van Otterloo & Co., said margins will send stock markets tumbling when they eventually revert to their mean. “The implication for the stock market is ugly, because it means earnings are unsustainably high,” Grantham’s colleague Ben Inker, GMO’s director of asset allocation, said in a telephone interview. GMO, an investment manager that oversees $93 billion, puts the fair value of the Standard & Poor’s 500 Index at between 950 and 1,000, compared with the 1,158.67 level at which it closed last week. U.S. companies’ ability to squeeze more profit from each dollar of sales is pushing earnings higher, even as the economy has grown at a below-average clip since the recession ended in June 2009. Grantham, who called corporate profits “freakishly high” in an August commentary, sees wide margins as an aberration. Some of his competitors say changes in the economy and the way firms operate could keep them near peak levels for another year or two.


Everyone agrees that earnings are cyclical except when they are at a high.  So are earnings at a peak?

The first chart below shows S&P operating earnings (red line) and 12-month forward forecasts  shifted ahead 12 months.  The second chart shows the difference between the forecasts and actual releases.  The shaded areas highlight official recessions.

Wall Street is one of the few places where practice does not make perfect. Notice that every subsequent recession sees larger earnings error rates than the previous recession.

During the 1990/1991 recession, top-down forecasters (strategists) were too optimistic by 10%.  Bottom-up forecasters (adding up the 500 company forecasts) were too optimistic by 25%.

During the 2000/2001 recession, top-down forecasters were too optimistic by 25%.  Bottom-up forecasters were too optimistic by 23%.
During the 2007/2009 “Great Recession”, top-down forecasters were too optimistic by 39.6%.  Bottom-up forecasters were too optimistic by 40%.

Also notice the difference between the top-down and bottom-up forecasts.  Strategists are getting significantly worse at predicting earnings than their 1980s and 1990s counterparts.

What Does This Mean?

If the economy goes into recession, earnings forecasts are not 10% to 12% too high.  Instead they might be 20% to 40% too high.  In other words, if the economy goes into recession, the earnings forecasts are horribly wrong.   They might be so wrong that one can make the case that the market might be overvalued. We believe this is part of what is bothering the markets, the epiphany that the economy is much weaker than expected and a recession will blow a hole in earnings forecasts to the point that the market might not be cheap anymore.

Source: Arbor Research

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