Why company analysts are completely wrong about the rebound
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Associate Editor
David Stevenson Sep 03, 2009
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Analysts: who's right?
A headline caught my eye on Bloomberg yesterday. It read "Goldman v Goldman on Capital Spending". The latest high-profile divorce case about to be splashed over the tabloid media?
Well, no. It was a rather less sensational story about how analysts at Goldman Sachs are divided over how much US companies will be spending next year.
That doesn't sound too interesting. But in fact, the issue that's splitting Goldman is a big deal for economies, and for stock markets too. Here's why – and here's what you should be doing about it...
Individual stock analysts (also known as 'bottom-up') are normally much more upbeat than their colleagues over in the top-down strategy department (these are the analysts who look at the big picture, macro-economic side of things, rather than individual companies). And this is exactly what's happening at Goldman Sachs, says Bloomberg.
The investment bank's industry analysts reckon there'll be a 2% bounce back next year in capital spending (also known as 'capex') by American companies. In other words, they believe that US firms are going to be spending more money on new equipment and investing for the future growth of their businesses.
Now, the only reason these firms would do this is if a genuine economic recovery were imminent. If this is the case, then it would mean that the 50%+ recent rally in the share prices of 'cyclicals' such as commodity producers and industrial manufacturers would be at least partly justified. Not just in the US, but over here, too.
Are analysts' upbeat forecasts right?
But what if this take on things is wrong? Goldmans' top US strategist, Davis Kostin, completely disagrees with his analyst colleagues. He reckons US capex spending will dive by 15% in 2010, on top of an expected 22% fall this year. That would add up to the biggest fall in corporate spending seen in the States for more than 25 years. He also expects research and development spending, another harbinger of future growth, to fall by 15% next year.
In other words, don't bank on the 'economic recovery' being anything more than a flash in the pan. Charles Minter of Comstock Partners calls this: "a quarter or two of rising GDP based on massive government spending, a slowdown in inventory deceleration, the 'cash for clunkers programme" – the US government's scheme for replacing old cars with new ones – "and some misleading housing numbers".
So who's right?
We'd side with the top-down strategists. As we've pointed out in the past, individual analysts tend to get far too excited about the prospects for the companies they cover. That leads them to mark up their profit forecasts too far, only to slash them back again later. You can see just how bad analysts are at forecasting earnings in the chart below, compiled by James Montier (formerly of Societe Generale), last October. The red line shows the trend in actual earnings; the black line shows analysts' forecasts. As you can see, the analysts' 'forecasts' actually tend to be a reflection of recent history, rather than any having any predictive value whatsoever.
We're seeing more of the same right now. Standard & Poor's adds up all the earnings forecasts made by individual analysts for the companies in the S&P 500 index for the next 18 months or so. The latest results are stunning. Even although the US is suffering just about its worst recession since WWII, 'bottom-up' analysts are predicting an overall increase in earnings this year of nearly 10%. For 2010, a staggering 35% rise in profits has been pencilled in.
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It's happening over here too. As Algy Hall in the Investors Chronicle, puts it, "the City's finest have been falling over themselves to upgrade forecasts for full-year 2009 and beyond".
Serious disappointment is in store for stock market investors
Yet again, as share prices have gone up, analysts have been ratcheting up their earnings forecasts in response. But unless there's a robust economic pick-up next year, they'll be disappointed. Unfortunately for them, a pick-up looks very unlikely.
As David Rosenberg of Gluskin Sheff, who's been a consistent voice of sanity amid all the euphoria, keeps pointing out, the statistics suggest that businesses are doing extremely badly. US company sales in the second quarter of 2009 were down 25% year-on-year, worse than the 15% first quarter fall. And it looks like we'll see another 20%-odd fall for this quarter. "So the notion that earnings are improving is… well, not supported by the facts."
In other words, all those profit forecasts for full-year 2009 are looking seriously wide of the mark. As for hopes for a big pick-up in profits next year, well they look completely delusional.
That will mean some serious disappointment for stock market investors as they gradually realise that companies have no hope of meeting analysts' expectations. And those cyclical stocks – the ones that have shot up the furthest – are set to be the worst hit of all.
The best place to invest in the stock market right now
So if you're going to leave some money in the market right now, the best place to invest will be in stocks that should do well when others are falling. Of course, we like big blue-chip defensive plays, which we've discussed regularly in Money Morning. But if you'd like to take a chance on some smaller cap plays that should be insulated from events in the wider economy, you may also want to consider some of the tips from the experts at our most recent Roundtable - Twelve stocks that will weather the storm - if you're not a subscriber already, you can claim your first three issues free here.
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