After the biggest flub, analysts’ credibility gets a drubbing
After the biggest flub, analysts’ credibility gets a drubbing
New York: When Wall Street’s almost 1,800 equity analysts figured US earnings growth for the third quarter of 2007, they were 8.2 percentage points too high. Forecasts for the fourth quarter were wrong, too, overestimating profits by 33.5 percentage points, the biggest miss ever.
It’s no wonder investors don’t trust analysts, says Liz Ann Sonders, chief investment strategist at Charles Schwab Corp., which oversees $1.4 trillion (about Rs56 trillion) for clients. Merrill Lynch and Co., Bank of America Corp. and the rest of the securities industry aren’t losing credibility because of anything sinister. The problem is they didn’t get their math right after credit markets froze nine months ago.
As Alcoa Inc. kicks off first-quarter earnings season on Tuesday, analysts say 2008 will be the best year ever for US profits, data compiled by Bloomberg show. Earnings for companies in the Standard and Poor’s 500 Index (S&P 500) will rise 10.7%, even after US Federal Reserve chairman Ben Bernanke acknowledged that the economy may fall into a recession and banks reported $232 billion of writedowns and losses, the forecasts show.
The analysts are “going to lead you off the cliff," said Richard Weiss, who oversees $60 billion as chief investment officer at City National Bank in Beverly Hills, California. First quarter earnings will be “a big wake-up call for some analysts who are sitting on big double-digit numbers," he said.
The S&P 500 dropped almost 10% in the first quarter, the worst start to a year since 2001, as increasing unemployment, record mortgage delinquencies and a retreat in consumer confidence signalled that the economy is falling into a recession.
Buy, hold
Even with the decline, analysts’ recommendations to buy or hold US shares climbed to 94.5%, the highest rate in more than five years.
US stocks posted their biggest advance in two months last week on increasing confidence that banks and brokerages will survive losses from the collapse of the subprime mortgage market. The S&P 500 gained 4.2%, while Europe’s Dow Jones Stoxx 600 rose 4.1%, its steepest increase in a year. The MSCI Asia-Pacific Index added 2.5%.
On Tuesday, the S&P 500 advanced 0.2% to 1,372.54.
The S&P 500 is valued at 13.9 times the estimated earnings of its component companies, the least compared with reported profits since 1990, according to Bloomberg and S&P data. The ratio is based on analysts’ forecasts that show companies in the S&P 500 will earn a total of $99.67 a share in 2008.
That’s more than the $87.72 a share S&P 500 companies earned in 2006 and would be the highest profit on record, data from S&P showed.
Profit assumptions
Getting there hinges on companies rebounding from projected earnings declines of 11.3% and 3.5% in 2008’s first and second quarters, Bloomberg data show. Income from continuing operations will rise 13.9% in the third quarter and jump 54.5% in the fourth, according to the forecasts. The per-share earnings are based on profit estimates for the S&P 500, adjusted for each company’s weighting.
Alcoa, the world’s third largest aluminium producer, was the first company in the Dow Jones Industrial Average to report earnings for the first quarter. The New York-based company said first quarter profit, excluding some items, fell to 44 cents a share because of surging energy costs, a weaker dollar and lower metals prices. The company was expected to earn 50 cents, the average analyst estimate compiled by Bloomberg showed.
Analysts are “way out of line," said Joseph Quinlan, chief market strategist for the investment management unit at Bank of America, which oversees $643 billion in client assets. “There’s enough uncertainty about the overall health of the economy to keep investors on edge."
Virtual standstill
The US economy has slowed to a “virtual standstill", the International Monetary Fund said last week. The fund reduced its forecast for US economic growth this year to 0.5%, the lowest since the 1991 recession.
Home prices fell by the most on record in January, unnerving Americans who said last month their outlook for the economy was the worst since the Watergate scandal in 1973. Economists expect consumer spending, which accounts for two-thirds of the economy, to grow this quarter at the lowest annual rate in 17 years.
Wall Street predictions in the second half of 2007 were too bullish even after analysts cut them. At the start of the third quarter, average estimates called for earnings to increase 5.7%. By the end of the quarter, analysts had cut by more than half to 2.7%. Companies ended up reporting a 2.5% drop in profits.
Widest misses
The forecasts were even farther from the mark in the fourth quarter. Analysts predicted 10.9% growth before flipping the projection to a decline of 7.9%. S&P 500 companies reported that profit dropped 22.6%.
Earnings estimates for US consumer-related companies, materials producers and financial firms missed by the most. Analysts predicted profit increases of 17.4%, 10.4% and 1.6%, respectively.
Consumer companies reported a 10.3% decline in fourth quarter earnings, and materials suppliers a 4.5% drop. Financial companies posted losses.
“Even the best analyst of the banking sector has a tough time trying to gauge what the writedowns will be," said Schwab’s Sonders. “The consensus is that we’ll have a tough first and second quarter and then we’ll get some liftoff. That may be too pat an assumption."
Merrill’s Guy Moszkowski, the top-ranked analyst for financial firms in Institutional Investor’s 2007 survey, said at the start of the fourth quarter that Citigroup Inc., the largest US bank by assets, would earn $1.08 a share. By 8 January, Moszkowski had reversed to an estimated loss of $1.43, the most bearish among 18 analysts tracked by Bloomberg.
Biggest loss
A week later, Citigroup reported a loss of $1.99 a share, the biggest in its 196-year history. The bank wrote down the value of its subprime mortgage investments by $18 billion, causing the stock to lose 14% of its value that week.
Moszkowski maintains a “neutral" rating on Citigroup’s stock, which he established on 28 August. The rating indicates the analyst anticipates the 12-month total return to be flat to 10%. Since his call, Citigroup has fallen 45%, including dividends.
Moszkowski declined to comment on his recommendations, according to Merrill Lynch spokeswoman Susan McCabe Walley.
Even analysts who reduced their estimates for banks failed to anticipate the extent of the damage.
Meredith Whitney, a New York-based analyst at Oppenheimer and Co., correctly predicted on 31 October that Citigroup would cut its dividend because of credit market losses, more than two months before the lender slashed its payout. Still, Whitney forecast a 45 cent fourth quarter loss. At the start of the period, she had estimated profit of $1.03 a share.
Bank of America Corp.’s Robert Ohmes, ranked the No. 1 apparel analyst by Institutional Investor, predicted Liz Claiborne Inc. would report fourth-quarter profit of 70 cents a share. He cut the estimate almost 75% to 19 cents on 22 February after the New York-based maker of Kate Spade handbags and Juicy Couture clothing reduced its 2007 profit forecast.
On 13 March, the company reported a fourth quarter loss of $4.55 a share, after writing down the value of the department store brands it’s selling or overhauling.
Ohmes, who dropped coverage of the company on the same day, had maintained a “neutral" rating since the start of the fourth quarter. The rating indicated that he expected a total return between 14.9% and minus 2.9% on Liz Claiborne stock. During that span, the company’s shares plummeted 50%, including reinvested payouts.
The New York-based analyst left Bank of America last month, according to spokesman Brandon Ashcraft.
Dotcom bubble
The last time analysts lost this much credibility with investors was in 2002. That’s when Wall Street agreed to pay $1.4 billion in fines and restitution after investigators found that analysts were distorting research during the dotcom bubble in the late 1990s to gain investment banking business from companies.
“There’s a lot of very, very good sell-side analysts," said Kevin Caron, a market strategist at Stifel Nicolaus and Co., which manages $50 billion. “But if you’re on the buy side committing money, I hope to God you’re coming up with your own numbers." Bloomberg
Jeff Kearns, Elizabeth Stanton and Van Tsui in New York contributed to this story
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