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VOLUME 12
ISSUE 14 guestperspective By Bill Hester
JULY 16, 2010

INSIDE Take With Grains of Salt

Wall Street’s Big Earnings Expectations Ignore Economic Divergences
This week brings the official start to second- rise above 15 percent, annualized total returns
guestperspective

quarter earnings announcements. As the mech-
anism for data delivery gets switched from the
faucet to the fire hose, investors may want to
keep a few things in mind as the reporting sea-
son progresses. Lofty earnings expectations
result in poor stock market performance, on
average. Forecasts for expected earnings are
typically the most misleading at economic
inflection points. And less frequent and less cel-
ebrated data such as the Purchasing Managers
Indexes may provide a better view of future
profits than analyst’s expectations. The diverg-
ing trend between the PMI data and earnings
expectations will be important to watch.
The chart below gives one perspective into how
bullish stock analysts currently are. The data is
compiled by Ned Davis and it shows the median
estimated one-year earnings growth rate for the
companies in the S&P 500. Analysts are now
forecasting more than 21 percent earnings
growth for the median stock over the next year,
a record level in the 30
years of data.
fall to -12 percent. Stocks are more vulnerable
when robust earnings growth is already
assumed by investors.
Projected earnings growth by Wall Street ana-
lysts is also far less “forward looking” than one
might imagine. The graph below plots the
median expected 12-month forward growth
rate expected by analysts, along with the per-
centage change in actual S&P 500 earnings per
share over the preceding year. At each point on
the graph, the growth rate that analysts expect
for earnings over the next year is plotted with
the actual change in earnings over the prior
year. The graph shows that they shadow each
other closely. This suggests that forecasted
earnings for the next year are little more than
an extrapolation of the change in earnings over
the prior year. The correlation between year-
ahead earnings growth expectations and the
actual growth in earnings over the same period
is .28 (statistically, this means that Wall Street’s

As Ned Davis has

noted, stock returns
are usually consider-
ably weaker beginning
from periods with high
earnings expectations.
The stock market has
risen 18 percent on an
annualized basis when
earnings expectations
are below 5 percent.
When expectations

RESEARCH
welling@weeden JULY 16, 2010 PAGE 1
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forecasts explain less
than one-tenth of the
variation in actual
earnings growth over
the following year).
The correlation
between year-ahead
growth expectations
and the change in
earnings over the prior
year is .75.
Analysts are heavily
influenced by recent
earnings performance.
So it’s not surprising to see the current high economists told Bloomberg they expect the
earnings expectations considering the strong U.S. economy to grow 2.8 percent in the third
rebound in S&P 500 earnings over the past quarter, down from 3 percent a month ago. At
year. But, in a year’s time, the record suggests the same time, stock analysts have continued to
increase their estimates for earnings growth.
they’ll likely be wide off the mark.
A more valuable indicator of future profits may The graph on page 3 attempts to contrast the
be the ISM’s manufacturing report. Even erosion in the global PMI indexes against the
though manufacturing represents a declining rising optimism of stock analysts. Six series of
share of economic output, it continues to be data are plotted: the changes in earnings
responsible for the some of the most volatile expected for the companies in the S&P 500 and
components of GDP – and corporate profits. the Euro Stoxx Index, and four PMI indexes for
The graph below compares the level of the PMI the U.S., the Euro area, Germany, and China.
Index and the year-over-year changes in S&P Each of the series is indexed to 100 in April, the
500 Index earnings shifted forward by six month where most of the PMI data peaked.
months (the blue line).
The chart shows the growing divergence
It’s this correlation between manufacturing between expectations for earnings and the
indexes and profits that can partly explain the global PMI indexes. These indexes will be
weakness in the global markets during the last important to watch over the next couple of
two months. That’s because the U.S. months. As John Hussman noted in Recession
Purchasing Managers Index is not alone in Warning (w@w, Guest Perspective 7/16/2010),
looking as if it is rolling over. Of the G7 coun- three of the four metrics that provided a warn-
tries, 5 domestic PMI indexes fell last month. ing of an approaching recession in 2007 are in
Germany’s index was unchanged and Italy’s place. A drop in the PMI index to 54 or below is
rose marginally. China, Taiwan, Singapore, and the remaining indicator in that original set of
India metrics have also metrics that hasn’t signaled. But the weakness
fallen in recent data.
While these indexes
still sit above 50, indi-
cating expansion, the
shared peak, mostly in
April, and decline in
their levels has
investors worried.
Economists are
responding to the soft-
ness in the leading
indicators. In their
most recent survey,
welling@weeden JULY 16, 2010 PAGE 2
in the growth rate of
ECRI’s Weekly Weeden & Co. LP’s
Leading Index – which Research Disclosures
leads the PMI by about In keeping with Weeden & Co. LP’s
reputation for absolute integrity in its
three months – when dealings with its institutional clients,
combined with the w@w believes that its own reputation
other indicators are for independence and integrity are
essential to its mission. Our readers
currently enough to must be able to assume that we have
expect a period of no hidden agendas; that our facts are
renewed weakness. thoroughly researched and fairly pre-
sented and that when published our
analyses reflect our best judgments,
Therefore there are not vested pocketbook interests of
two dynamics that are our sources, colleagues or ourselves;
w@w’s mission is strictly research.
now in place that were
This material is based on data from
also in place near the sources we consider to be accurate
end of 2007. Global and reliable, but it is not guaranteed
earnings expectations as to accuracy and does not purport
to be complete. Opinions and projec-
are climbing while tions found in this report reflect
global PMI indexes are either our opinion (or that of the
declining and there is named analyst interviewed) as of the
report date and are subject to change
sufficient evidence in without notice. When an unaffiliated
hand to be concerned interviewee’s opinions and projec-
about a period of tions are reported, Weeden & Co. is
relying on the accuracy and com-
renewed weakness in pleteness of that individual/firm’s
the U.S. economy. The own research disclosures and
graph at right shows assumes no liability for same, beyond
reprinting them in an adjacent box.
the period between This report is neither intended nor
2007 and 2008 using should it be construed as an offer to
the same indices (leav- sell or solicitation or basis for any
contract, for the purchase of any
ing out China in this security or financial product. Nor has
case because its econo- any determination been made that
my peaked in 2008). It any particular security is suitable for
any client. Nothing contained herein
shows the same diver- is intended to be, nor should it be
gence in earnings considered, investment advice. This
expectations and PMI report does not provide sufficient
information upon which to base an
indexes along with investment decision. You are advised
when the recession sig- to consult with your broker or other
nal was given in 2007. financial advisors or professionals as
appropriate to verify pricing and
other information. Weeden & Co. LP ,
The spread between the changes in global PMI Reprinted with permission of Bill Hester and its affiliates, directors, officers and
Indexes and global earnings expectations is an Hussman Funds’ Investment Research & associates do not assume any liabili-

increasing concern, especially considering the Insight. ty for losses that may result from the
reliance by any person upon any such
evidence that increases the probability of information or opinions. Past perfor-
renewed economic weakness. Earnings growth mance of securities or any financial
instruments is not indicative of future
forecasts have never been higher measured by William Hester, CFA is a Senior Financial performance. From time to time, this
the median expectation. This alone, typically Analyst at Hussman Funds and author of firm, its affiliates, and/or its individ-
leads to poor stock performance. The growing ual officers and/or members of their
Investment Research & Insight. families may have a position in the
gap between PMI Indexes and earnings expec- subject securities which may be con-
tations increases these potential risks. sistent with or contrary to the rec-
ommendations contained herein; and
may make purchases and/or sales of
those securities in the open market
or otherwise. Weeden & Co. LP makes
a market in numerous securities., but
none are featured herein. Weeden &
Co. LP is a member of FINRA, Nasdaq,
W@W Contributor Research Disclosure: William Hester, CFA is a Senior Financial Analyst at Hussman Funds and author of Investment Research & Insight. This Guest Perspective is reprinted and SIPC.
with permission of Hussman’s Investment Research & Insight, July 2010. All rights reserved and actively enforced. Except for articles hosted from the web domains hussman.net or hussman-
funds.com, linked articles do not necessarily reflect the investment position of the Funds.
**Full Disclosure: Kate Welling owns shares in the Hussman Strategic Growth Fund and Hussman Strategic Total Return Fund.

welling@weeden JULY 16, 2010 PAGE 3