The Flawed Reasoning Behind Wall Street’s Expectations

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tdp2664 InvestorPlace The chicken is clueless about the egg’s fate. Will it hatch or become an omelet? Wall Street is clueless about their forecasts. Will they “hatch” or become egg on their face? Who cares? As long as it sounds good at the time, Wall Street’s opinions are promoted by the media. Is this a haphazard approach? Judge for yourself. The most recent Wall Street blunder was the overemphasis on positive earnings in April. Here are some of the headlines Wall Street and the financial media featured late April 2011: “Morgan Stanley shares rise as earnings beat estimates” “Stocks, commodities rise as earnings top estimates” “Leading U.S. indicators, consumer confidence gain as fuel costs discounted” “World revs up U.S. profits” “The Global economy is improving” “The S&P breaks out” “The Dow’s going to 20,000″ “Sales growth the big surprise on Wall Street” “Buffett says odds of another U.S. banking crisis low” “Equities finally seeing light on the economy” “Stocks find sea of tranquility” Flawed Reasoning The chart below reveals the flawed reasoning behind Wall Street’s expectations. It plots earnings per share against GDP and U-6 unemployment numbers. Notice how earnings for Q1, Q2 and Q3 2011 were supposed to reach a new all-time high. There were at least four reasons why record high EPS estimates were not long-term bullish: GDP was contracting, U-6 (and every other measure of unemployment) did not signal a recovery. Every spike in EPS would be temporary and unsustainable. EPS estimates are just a projection and are about as valuable as an unhatched egg. The last time EPS reached an all-time high was in Q2 2007. We all know what happened thereafter. EPS or P/E ratios can be distorted via financial trickery. Financials and banks took advantage of this when accounting rule FASB 157 was changed April 2, 2009. This allowed banks to hide trillions of dollars of unrealized mortgage losses in an accounting loophole that doesn’t affect the income statement and earnings. Thus some of bank’s losses were included in earnings numbers. Buying at current prices with the expectation of long-term gains is almost certain to deliver despair and tears. Proceed With Caution P/E ratios or EPS aren’t a short-term timing tool and didn’t prevent stocks from rallying since the above analysis. Nevertheless, a major market top was expected. On April 3, we said: “In terms of resistance levels, the 1,369 – 1,382 range is a strong candidate for a reversal of potentially historic proportions. Bullish bets should be watched very carefully, especially once stocks move above 1,356.” The summer 2011 meltdown erased all gains going back as far as December 2009. Yes, more than 18 months of gains were eliminated within a matter of weeks.