Home Business Equities Have Rallied Despite Consistent Earnings Estimate Downgrades

Equities Have Rallied Despite Consistent Earnings Estimate Downgrades

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Global equity markets dipped 1.5% last week, but they are still up 18% for the year on the back of multiple re-ratings and early signs of an economic recovery in North America and Europe, but the steady stream of negative earnings estimate revisions is a sign that investors’ bullishness on equities may not be completely justified.

“Factors limiting the further advance of the equity market include poor company fundamentals,” writes Citi analyst Andrew Lapthorne. “This is reflected in the high quantity of downgrades being posted by consensus. Downgrades to Q4 EPS estimates have outnumbered upgrades by a ratio of two to one over the past couple of months.”

Downgrades don’t normally result in very positive returns

Of course analysts have an incentive to revise estimates against their recommendations (revising long positions down and short positions up). “That corporates pre-position the consensus prior to reporting is nothing new, but the fact that it has gone on largely unnoticed is quite striking,” writes Lapthorne. “When the rate of downgrading has been this bad, equity markets have typically posted negative, not very positive quarterly returns. Surely low interest rates are not the only reason investors are buying equities.”

Recent equities pullback varies widely by region

When you break the story down into regions, significant differences emerge. The UK FTSE All Share (INDEXFTSE:ASX) and the MSCI Eurozone index are both off 5% of their recent peaks. Australia and peripheral EU countries including Spain and Portugal are down about 6% from recent peaks, and emerging markets are down 6.1% year-to-date. The US has had a much smaller pullback in comparison, and even then some of it can be explained as profit-taking and year-end tax-loss selling.

Depending on your point of view, US equities have fared better during the second half of the year either because the US economy is rebounding faster than most of the world, or because QE is supporting businesses that would be struggling without such an accommodative monetary policy. Net earnings estimate revisions is only roughly correlated to stock prices, but if that’s the only piece of information you had to work with you’d conclude that something is very off in the US market. As pressure builds for the Fed to start tapering already, we shouldn’t have to wait long to find out which is correct.

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