“Equity analysts are generally too optimistic with their earnings forecasts. They generally have to downgrade their EPS estimates from one month to another. Equity analysts start to give estimates for the calendar year two years ahead in February.”
Habib F. Faris
LONDON, 10 March 2003 — Most investment strategists agree that currently valuation indicators signal that equity prices are attractive especially relative to bond prices. As the popular price to earnings ratio (PER) is the equity price divided by estimated earnings per share (EPS), the assessment that equities are attractively valued breaks down if earnings estimates are too optimistic. In answering the question whether equity analysts are overly optimistic we refer to the consensus earnings estimates collected by the International Brokerage Estimate System (IBES).
Equity analysts are generally too optimistic with their earnings forecasts. They generally have to downgrade their EPS estimates from one month to another. Equity analysts start to give estimates for the calendar year two years ahead in February. For example, the first consensus estimate for 1987 EPS for the S&P 500 is made in February 1985. Equity analysts were too optimistic with their first estimate they made for any of the last 17 years and the final reported EPS for the S&P 500 was below their first estimate.
The first estimate for a particular calendar year has been on average around 24 percent higher than the reported effective EPS for the same calendar year. Especially in the recession years 1991 and the year following the recession in 1992, earnings estimates (made in February 1989 and February 1990) were exceeding effective EPS numbers by more than 50 percent. In the years of the equity boom between 1997 and 1999, consensus earnings also over-estimated reported effective EPS.
We may be too stringent when we evaluate the forecasting capability of equity analysts by comparing the first estimate for a calendar year still more than two years away to the reported effective EPS. Therefore, we also compare the earnings estimate made at the end of each year for the following year with the effective reported EPS. This forecast had an upward bias, too. Only for 1988, 1994, and 1995, were the estimates beaten by the effective reported earnings; in all other years, they exceeded reported earnings. The highest forecast errors happened in 1991 and 2001, the years of the last two economic recessions. During the last 16 years, EPS estimates on average exceeded effective EPS by 13 percent.
Thus disillusioned with the quality of earnings estimates, one might ask if we should use them at all answer is no. As the equity price should be identical to the discounted value of all dividend flows in the future (dividend discount model), expected earnings not past earnings should be used to calculate PERs. The fact that earnings estimates generally have an upward bias does not bother us, as we compare the current PER with the average of the PER during the past. By comparing current and past figures, with their respective bias, we still get the correct signals.
The current PER of the MSCI World is below the historical average. It gives a weak buy signal for equities only, as the PER is not more than one standard deviation below the historical average. The risk premium however, which we define as the ratio of earnings yield divided by 10-year bond yield, is now extremely high, giving a strong buy signal for equities.
We have a neutral weighting on equities at the moment. Given the attractive valuation of equities should we not be overweight in equities? For the time being, we believe that the equity risk premium will remain high as geopolitical tensions continue or intensify.
Hopes that accounting scandals are a problem of the past was disappointed with the admission of Ahold and Qwest that there have been irregularities in their accounts. Besides, the newest business cycle indicators sent out a weak signal. For example, the ISM purchasing manager index declined to 50.5, indicating only modest GDP growth. Normally, earnings estimates correlate highly with the purchasing manager index. Therefore, we see the danger that forward earnings will grow only modestly or even decline in the next months.
(The information contained herein is for information only and should not be construed as an offer or a solicitation to purchase, subscribe, sell or redeem any investments. While Clariden Bank uses reasonable efforts to obtain information from sources which it believes to be reliable, Clariden Bank makes no representation or warranty as to the accuracy, reliability or completeness of the information.)