“Forecasting is challenging,” SocGen’s Andrew Lapthorne wrote, in his latest. “Some would say impossible.”
He’s right on the first point. On the second point, I’m one of the “some.” If what we’re forecasting has anything to do with markets or macroeconomics, it’s impossible — the forecasting.
The reason it’s impossible is simple: We’re dealing with human behavior, and humans are a volatile, mercurial bunch. Today, everything’s great. Tomorrow, the world’s ending. That’s humans for you. Oscillating between euphoria and despair. Those fluctuations manifest in economic decisions and they’re particularly pronounced in market behavior, markets being the casino that they are.
If you’re looking to explain out-year earnings growth forecasts, the futility of forecasting is a good place to start. The challenging nature of the prediction business “is why analysts tend to start with similar growth rates of around 10-12% for years beyond the current year,” Lapthorne said.
SocGen’s data now includes 2025 consensus figures, and not surprisingly, “analysts have a very rosy outlook… with 11.8% growth forecast in 2024 for [a] universe of around 9,000 stocks, followed by a further rise of 12% in 2025,” Lapthorne went on to note.
But maybe it is surprising. The rosy outlook, I mean. Because history shows that when the Fed’s cutting rates, forward profit expectations are generally falling. And the market expects 150bps of Fed cuts this year.
If the Fed’s easing, it usually means growth’s mediocre, at best. At worst, there’s a recession or one in the offing. And that’s not great for profits.
“Declining profits and interest rates tend to go hand in hand, but right now, this is nowhere near the market expectation for this year, and there has been next to no change in US quarterly EPS estimates in recent months,” Lapthorne wrote, before asking, “Is this the calm before the storm?”
Revenue = Price times volume for each product or service a firm sells, summed for all products. The variable cost of each of those products is the cost per unit of each product’s inputs times the quantity of those inputs. That means there are essentially only four strategies a firm may employ to manage its gross margin which is the net revenue that is available to cover all the firm’s fixed costs. The firm may 1) Increase selling prices, 2) Increase the volume of a product sold, 3) Lower unit costs, and 4) Decrease the quantity of inputs per unit. That’s it. And these four components of profit are not entirely independent. If a firm attempts to rely on component 1), the likely result is inflation. Increasing volume, cet par, is very difficult for any legacy firm without lowering prices to try to take advantage of favorable elasticity. The result of using 2) as a strategy will require the firm to increase capacity or at least some fixed costs, negating much of the favorable effect of the price decline. Cost management (items #3 and #4) is the preferred method to increase profits because its easier but there are limits to that approach as well. How many of you have pushed your hand down on your car hood lately? The steel is so thin it’s almost transparent now (that’s item #4 above). And so forth. The upshot of this perhaps tedious recitation is that 10-12% increases in profits are a fantasy unless the firm engages in some form of financial engineering. Real growth (item #2 above) is lucky to breach 2% for most US industrial legacy firms. So we create inflation (Pepsi, General Mills, etc) or cut costs until we no longer can. Cutting prices may increase volume slightly if one is a monopolist (and then it would be silly to choose) and if a firm is part of an oligopoly, which includes the whole S&P 500, then the only result is a profit decline because all one’s competitors will follow. So count me in the bear camp for 10-12% profit increases this year. Having this happen for seven firms isn’t enough.
That is the old school approach. Modern “innovations” like stock-based compensation and ignoring other non-cash charges (EBITDA), massive stock buybacks and focusing on non-GAAP EPS rather than margins, help mightily to achieve that 10-12% “growth.”