HUMMONEY - Disappointing Realities (Perspective)

I want to bring to your attention some important findings from a recently updated report released by McKinsey & Co. regarding the accuracy of Wall Street analysts’ earnings forecasts. The following remarks should prove instructive:

• “Only in years such as 2003 and 2006 where strong economic growth generated actual earnings that caught up with earlier predictions, do forecasts actually hit the mark.”
• “When economic growth accelerates the size of the forecast error declines; when economic growth slows, it increases.”
• “Moreover, analysts have been persistently overoptimistic for the past 25 years, with estimates ranging from 10 to 12 percent a year, compared with actual earnings growth of 6 percent.”
• “… long-term earnings growth for the market as a whole is unlikely to differ significantly from growth in GDP, as prior McKinsey research has shown.”

So what should we learn from these points?

• Analysts’ forecasts are highly inaccurate. An additional caution that can be deduced is the questionable accuracy of company forecasts, which are the primary source of analysts’ information.
• The accuracy of forecasts declines as GDP slows. It’s a lot easier to be right when things are not so tough. 
• Corporate earnings highly correlate with GDP.

To incorporate this information for today’s world, we know that in the recent economic cycle GDP peaked in 4Q09 at 5.6% then declined to an estimated 2.5% in Q3 2010. Economic statistics thus far reported for the fourth quarter point to another quarter of deceleration. If this is the case, investors should be wary of earnings forecasts which paint a cheery picture. Realities may prove to be quite disappointing.   

---The views expressed here are of the author, HUMMoney contributor Greg Lewin; currently a General Partner at TLF Capital, an investment management firm. During the past 26 years he has been a senior money manager or partner in Wall Street firms including Neuberger Berman, Charter Oak Partners and Sailfish Capital.