Stock Analysts Right on Earnings as Investors Refuse to Agree

By Lynn Thomasson and Mary Childs

Nov. 2 (Bloomberg) -- Wall Street forecasts for the fastest U.S. earnings increase in two decades are failing to convince investors to pay a premium for the Standard & Poor’s 500 Index.

Companies in the gauge traded for an average of 15.4 times annual profit this year, or 0.6 times equity analysts’ projection for 2010 earnings growth of 25 percent, according to data compiled by Bloomberg. That’s the lowest so-called PEG ratio since 1995 and half the median of 1.3 since 1961.

The smaller valuations relative to income growth show investors don’t believe earnings forecasts, which are 10 times higher than economists’ prediction for U.S. gross domestic product, says Charles Stamey, who helps oversee $24 billion at Manning & Napier Advisors Inc. Bulls say analysts got it right during the steepest rally since the 1930s and that stocks are cheap when measured by the PEG ratio, a favored tool of Fidelity Investments fund manager Peter Lynch.

“We’re in as bad a time as we’ve ever seen to be projecting future earnings,” said Stamey, who is based in St. Petersburg, Florida. “In this environment, earnings estimates should be significantly questioned, and that’s your starting point in a PEG ratio.”

Concern the U.S. economy won’t grow enough to justify the S&P 500’s 60 percent advance since March sent the benchmark measure for U.S. equities down 4 percent last week. The index has retreated 2 percent since New York-based Alcoa Inc., the biggest U.S. aluminum producer, became the first Dow Jones Industrial Average company to report third-quarter results on Oct. 7.

Record Surprises

The drop came as a record number of companies beat third- quarter estimates and analysts raised forecasts for next year. The average projection for combined earnings among S&P 500 companies in 2010 climbed 2.5 percent last month to $77.36 a share, according to Bloomberg data.

The decline in stocks after releasing results suggests investors are questioning the earnings outlooks. Companies that reported in October fell 0.7 percent on average in the next trading session, the most in data going back to 2001, according to data released by Harrison, New York-based research firm Bespoke Investment Group LLC on Oct. 28.

Inflated estimates can push down the PEG, or the price- earnings ratio divided by income growth. Fidelity’s Lynch, who produced average annual returns of 29 percent managing the Magellan Fund from 1977 to 1990, said the ratio showed stocks offering “growth at a reasonable price.”

Lynch, 65, is vice chairman of Fidelity Management & Research.

Rise, Fall

Since the PEG shrinks as the outlook for profits climbs, a smaller ratio may show investors are speculating companies will fail to meet estimates, said Paul Baiocchi, who helps manage more than $1 billion at Delta Global Advisors in Huntington Beach, California.

“That’s the reason the market appears as cheap as it does, when in reality the market may feel that this is a rich valuation,” said Baiocchi, who recommended the Market Vectors Gold Miners ETF in January before a 24 percent rally. “The expectation for growth is not necessarily the same in the market.”

State Street Corp., the largest money manager for institutions, tumbled 20 percent since reporting profit that topped estimates by 4.7 percent on Oct. 20. The decline occurred even as the PEG ratio for the Boston-based firm stood at just over 1, or about 13 percent cheaper than the five-decade average for S&P 500 companies.

Beating Estimates

The price-to-earnings ratio for Southwest Airlines Co. has jumped more than fourfold since a low in March as the Dallas- based carrier rallied 68 percent and analysts lifted third- quarter forecasts from a loss of 5 cents a share to 1 cent a share in profit. The stock is down 16 percent since Oct. 14, the day before it reported profit of 3 cents a share for the period. Southwest, whose PEG reached 6.7 in January, now trades at 0.2.

Earnings estimates compiled by Bloomberg show companies in the S&P 500 will report combined profit in 2011 that is 54 percent higher than this year, the steepest growth in two decades. The projected increase for next year is 10 times faster than the gain in GDP foreseen by economists surveyed last month, near the highest ratio on record, based on data compiled by Bloomberg going back 60 years.

The U.S. economy expanded at a 3.5 percent annual rate in the three months that ended in September, according to Commerce Department data released Oct. 29. The pace is projected to slow to 2.4 percent in the current period and average 2.4 percent in 2010, economists’ estimates compiled by Bloomberg show.

Buy Signal

A low PEG ratio has historically been a bullish signal for equities. The S&P 500 rallied 16 percent on average the year after its PEG sank below the current level of 0.6, based on eight occurrences since 1961.

Shares are cheap because executives who overestimated the recession are being too conservative forecasting profits, according to Timothy Ghriskey, who manages $2 billion as chief investment officer at Solaris Asset Management LLC in Bedford Hills, New York. More than 80 percent of S&P 500 companies that have reported third-quarter profit beat analysts’ predictions, data compiled by Bloomberg show.

“There are always a large number of skeptics saying it’s going to be different this time, that future growth is not going to be as strong, that earnings aren’t going to be as strong,” Ghriskey said. “This is a very typical reaction, and it’s what prolongs a market rally coming out of recession.”

The S&P 500 posted the biggest drop since July on Oct. 30 as declining consumer confidence and spending and the threat of a CIT Group Inc. bankruptcy raised concern over the durability of the recovery. New York-based CIT filed for Chapter 11 yesterday with financing from investor Carl Icahn after the credit crunch dried up its funding.

“The market’s going to be wary of paying too high a multiple for earnings growth,” said Leo Grohowski, who oversees $151 billion as the New York-based chief investment officer at BNY Mellon Wealth Management. “The market’s in a show-me mode.”

To contact the reporters on this story: Lynn Thomasson in New York at lthomasson@bloomberg.net; Mary Childs in New York at mchilds4@bloomberg.net.