“Economists have begun to cut their top-down economic forecasts for GDP, and yet fundamental company analysts are sitting there like deer in headlights not knowing what to do with numbers,” Morgan Stanley Wealth Management CIO Lisa Shalett told Bloomberg’s Jonathan Ferro earlier this week.
It was a searing assessment that underscored rampant concerns about the stubbornness of earnings expectations in the face of gale-force headwinds to profitability, an extremely aggressive Fed and a US economy that’s downshifting in real time, notwithstanding intermittent signs of resilience.
I’ve argued repeatedly that estimates and margin forecasts desperately need to be trimmed, but, as Shalett went on to say, “we’re still looking at corporate earnings expectations that look — depending on what sectors you’re looking at — like 13% to 15% YoY profit growth off of 2021, which was an all-time high for operating margins and for profits as a share of US GDP.”
The figure (below) shows the progression of bottom-up consensus S&P EPS estimates going back to 2016.
Estimates for this year and next only recently flattened out after rising steadily. They need to fall, according to a growing chorus of alarmed market observers.
I’m not sure there’s much utility in feigning incredulity, though. While it certainly feels like the disconnect between, on one hand, profit forecasts, and, on the other, economic and policy reality is especially egregious in 2022, bottom-up consensus almost never gets it right initially.
“Post-recession recoveries are the exceptions when consensus margin estimates need to be revised higher, and this pattern was repeated in 2021,” Goldman’s Ben Snider wrote this week. “In most years, however, analysts model roughly 50-100bps of EBIT margin expansion before eventually revising those estimates lower,” he added. The figure (below) illustrates the point.
So, the amount of margin expansion currently embedded in estimates for next year is roughly on par with that typically seen by consensus prior to downward revisions. Snider did note that “the outlook for profit margins today looks less favorable than usual.”
What’s perhaps most concerning about all of the above is the extent to which it calls into question the usefulness of company analysts. If all they’re going to do is reiterate corporate guidance, they aren’t adding much value.
Shalett was very explicit in that regard. “It’s horrifying there is very little proactivity among bottom-up analysts to go out on a limb and cut numbers without corporate management telling them exactly what to do,” she said. “That’s problematic in terms of their value proposition to investors.”