The bull market in the S&P 500 from March 2009 through April 2011 was driven by strong earnings that more than offset the slight (though volatile) downtrend in the valuation multiple. Industry analysts never flinched during this period. They remained consistently bullish and consistently overcame the worries of investors, who were reassured by the fact that earnings beat even the analysts’ upbeat forecasts for the past nine quarters.
It all fell apart during August when valuations plunged, as I reviewed in yesterday’s Morning Briefing. The consensus forecast of industry analysts for the S&P 500 held up remarkably well through last week. But their forecasts for the S&P 400 and S&P 600 may be starting to fray at the edges. Investors seem to have concluded that a recession is coming. They know from experience that if a recession is coming, industry analysts are likely to be among the last to throw in the towel. The analysts tend to do a much better job of forecasting earnings during expansions than during recessions.
Of course, if instead of another recession, we get a protracted period of slow growth in both the US and global economies, as we currently expect, then there may not be much more downside in valuation multiples. On the other hand, there is downside in analysts’ consensus expectations for earnings given that we are now forecasting $100 a share for 2012, while the bottom-up forecast is around $113.