Tuesday, August 26, 2008

There They Go Again

commentary from this week's "Sector and Styles Strategy Report*:

Back on February 11th I wrote a report titled “What are the Sell Side Analysts Smoking?” The commentary and report focused on the excessively optimistic outlook earnings forecasts for 2008 by bottom-up analysts. Excessively optimistic in that top-down forecasts were substantially below the bottom-up numbers.

At the time, the bottom-up crew projected operating earnings for the S&P 500 for 2008 was an astounding +24% over 2007’s numbers ($102 versus $82.54). Whereas, the top-down forecasts had operating earnings for 2008 in mid $80s on down to the mid $70s.

Since then, particularly over the past two months, the bottom-up forecasts have gradually ground down to reality so much so that they have now reached the slightly negative territory of -2.4% (see Earnings Outlook on page 3 of the report*). One might therefore conclude that for 2009 the bottom-up boys and girls would factor in more of the data and analysis from the top down crowd but that is just not the case. For 2009, the numbers are equally, if not more, astounding.

According to the recent consensus forecasts, bottom-up earnings growth expectations for 2009 is a whopping +26%! Even after you exclude Financials you still end up with a +13.3% number. Excluding Financials and Energy gets you to 13.8%. And, lest you think that this dream state is restricted to the US, think again. The global numbers are a cool +18.7%, up from 2.8% currently projected for 2008.

Where does this thinking come from? How do you get such optimistic numbers when most top-down forecasts (from economists and investment strategists, often in the very same firms!) are much like this year – closer to 0%.

I believe a major part of the problem lies in the process by which bottom-up analysts go about making their forecasts. Specifically, when it comes to making earnings forecasts, many if not most bottom up analysts have a “silo” mentality, often acting as though there were no interconnections between their defined industries and companies and the broader macro climate. To be more specific on this point, I am not talking about your basic, tradition GDP starting point but rather the thematic and trend issues that are often hard to quantify such as the credit crisis and the risk of contagion therefrom.

Investment Strategy Implications

There is no news in stating that there are many risks facing investors as the last leg of 2008 unfolds and 2009 comes closer into view. Yet, what seems to be news to many bottom-up analysts is the interconnectedness and impacts from thematic and global macro trend issues.

Therefore, for the benefit of those who insist on using bottom-up forecasts exclusively, let me offer that the great risk for 2009 is the one I have written about time and again – credit related losses that move UP and OUT: UP the quality spectrum (within an asset group) and OUT to other asset groups, such as credit cards, student loans, auto loans, and corporate debt.

This danger is tied to the economic pain that results from deleveraging, with deleveraging not restricted to the banking industry but to the US consumer as he/she comes to terms with the consequences of a negative wealth effect and the need to repair their seriously overleveraged balance sheet. The result would be more savings, less spending, an extended period of subpar growth, and a transformation of the US and world economy away from its high dependency on US consumption.

Reliance on the traditional and the standard methodologies during times of economic transformation and change can and almost certainly will lead to faulty projections that can be very expensive.

*Published Aug. 25, 2008. Subscription required. For more information, click here

1 comment:

Valueman said...

Those using a bottom up approach to valuing individual firms will benefit from the use of an automated forecast DCF model which picks up trends in company economic performance and allows the user to make alternative assumptions about the economy growth rate and the cost of money. A few such models exist and are available for license.