Chart of the Day: Beware Downward Adjustments to Earnings Estimates

by John Lounsbury

David Rosenberg, chief economist at Toronto’s Gluskin Sheff, is continually publishing interesting graphs. Below one from today’s newsletter which shows the relationship between 12-month forward earnings estimates for the S&P 500 and the value of the index itself:

For about 2/3 of the 17 years the earnings forecasts and stock prices track each other reasonably well. However, going into the 2000 market top, stock prices moved up faster than earnings estimates. Going into the 2007 peak, earnings estimates moved up faster than the S&P 500 index. Now, in 2010, earnings estimates have again moved way ahead of stock prices.

It is a reasonable expectation that stock prices should move with a positive correlation to earnings. If that is the case over the next year either stock prices should rise or earnings should come down.

The above graph has been given some added notations below to point out that, for the third time in 17 years, there has been an 8-10% pullback in earnings estimates. In the two previous instances, stock prices have declined as the earnings estimates pulled back. See the areas between the vertical parallel lines.

In the current case, stocks have essentially settled into a trading range rather a bear market.

The interesting part is yet to come. In 2001 and 2008 there were brief rebounds in earnings estimates (near the latter vertical reference line) before a decline resumed. In both cases major earnings and market declines ensued.

Will the third bear market occur in the 2011-12 time frame, as suggested by the third arrow and question mark?

The answer will depend, in large part, on whether there is any follow through on the initial drop in earnings estimates and if those estimates precede earnings declines in the coming 4-8 quarters.