Bottoms Up and Up


New York – Here’s a multiple choice quiz: 2009 earnings for the S&P 500 are forecasted to a) decline by 15%; b) decline by 25%; c) grow by 31%.  Yes, it is a trick question.  The correct answer is (c).  As of March 2, the bottom up consensus estimates for the S&P 500 show an aggregated operating earnings in 2009 of $64, up 31% from $49 in 2008.  Is there an optimistic bias to these estimates?  Silly question.  Yet there is some method in the madness, as we shall see.

As we have noted in earlier blogs, bottom up analysis tends to be optimistically biased.  There is nothing nefarious about this, simply the natural tendency to extrapolate.  When analysts lower forecasts it is in the context of their extrapolations, resulting in incrementalism.  Bottom up analysis tends to be slow in assimilating the bad news, resulting in consistently high earnings estimates during declining markets, which become glaringly obvious when you aggregate them.

So by this logic, shouldn’t bottom up earnings estimates tend to undershoot as the economy improves?  Perhaps.  But this seems at least partly offset by optimistic assumptions about improving conditions.   It appears that bottom up analysis tends to assume quicker improvement in the operating environment than is currently justified.  This is the danger of relying too much on management guidance rather than more objective measures of industry strength.

This is not true for all sectors, however.  When you examine the sector level forecasts, the bottom up forecasts assume earnings declines in Materials (-39%), Energy (-38%), Industrials (-21%) and Technology (-6%).  You can argue the projected increases in Consumer Discretionary (+4%), Healthcare (+8%) and Telcom (+.5%) which assume improved earnings from 2008.  The increases in Consumer Staples (+5%), and Utilities (+2%) might be optimistic, but they show declines over 2008.

S&P 500 Operating Earnings

Not surprisingly, the problem child is Financials, which on a bottom up basis is projected to swing from an aggregate loss of $24 in 2008 to a profit of $10.6 in 2009.  If you exclude Financials, the bottom up estimates are declining over 20% in aggregate.  On a quarterly basis, the bottom up estimates have Financials going from a $16.5 loss in Q4 2008 (which made the aggregate S&P Earnings negative for the first time since S&P has been conducting the analysis) to a gain of $2 in Q1 2009.

The top down strategists tend to disagree with the bottom up estimates–as usual–but the good news is that the level of disagreement is not as large as when we last looked at this issue.  Bearish strategists such as Nouriel Roubini, founder of indie research firm RGE Monitor, are predicting $50 earnings for the S&P 500 ($14 lower than the bottom up forecasts) but his P/E is 12, higher than the 11 P/E derived by applying the current S&P price to the $64 bottom up forecast.  In other words, he is predicting a low of 600 on the S&P, not far from where we are today.  Another bear, David Rosenberg, North American economist at Merrill, has come up with the same forecast ($50 with a P/E of 12).

So, while it is likely that the bottom up estimates are too optimistic, much of this hinges on the outlook for one sector–Financials.  Excluding Financials, you can quibble with some of the sector estimates, but the bottom up estimates are plausible, a big change from 6 months ago when they were completely over the top.  And, the forward multiples suggest that the market is discounting the future earnings at a very healthy rate.  We may not be at the bottom, but we seem much closer than we were 6 months ago…

To get S&P’s weekly calculation of earnings by sector, click here.


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