Earnings Estimates or "Look, father, the security analysts wear no clothes!"

Prior to entering the hedge fund business in 1968, I spent my first four years on Wall Street as a security analyst. I felt that I added value to the equity portfolios of my firm's clients. However, I realized early on that most analysts parroted back what management told them. There was very little analysis. Most analysts were mere journeymen. Since then, whenever I hear what analysts in aggregate are estimating for the S&P 500 Index's earnings, the so-called "bottom up" approach, I ignore the findings. The better approach is the "top down" one, which scrutinizes macroeconomic variables.

In previous postings, I have mentioned that the aggregate profit margin of the companies in the 500 Index had reached 13% versus the normal 8%. This occurred in the year ending mid-2007, when earnings were $91.47. At that time, normalized earnings would then have amounted to 8/13 of those lofty earnings, or roughly $56.
Historically, normalized earnings have grown at a 7% compounded annual rate. (See my early posting entitled "The Seven Percent Solution".) So normalized earnings for mid-2009 would be $56 compounded for two years at 7%, or roughly $64.

I have long held the position that deleveraging the economy would cause a very serious recession. It wouldn't surprise me if earnings declined 25% from the normalized level. Reducing normalized earnings of $64 by 25% would bring earnings down to $48. The "bottom up" estimate for the four quarters ending mid-2009 is $86.95! Guess in which estimate I place more faith!