Why Aren’t Profit Forecasts Higher?

The summer rally has been based on better-than-expected earnings and signs of green shoots. The bulls claim that both are legitimate reasons for stocks to go higher. But if expectations have really improved, then why aren’t earnings estimates higher?

It’s question worth asking considering what the data is showing us.

Top-down projections (those made by market strategists at brokerage firms) call for full-year S&P 500 profits of $54.19 per share. This is the lowest the Zacks Consensus Estimate has been all year.

The bottom-up forecast (calculated by weighting the consensus earnings estimates for a firm within the S&P 500) isn’t much better. It calls for earnings of $60.43 per share, which is in within the range we’ve seen since March. (Because of the way it’s calculated, the bottom-up estimate tends to be more volatile.)

This hardly sounds like the stuff the rallies are made of, huh?

Part of the problem is that second-quarter surprises are not translating into better second-half forecasts. Take Caterpillar (CAT), for instance. The company recently topped expectations by 51 cents per share. Yet the 2009 Zacks Consensus Estimate has only risen by 35 cents. Even if we use the more bullish, most accurate estimate of $1.52 per share, second-half profit projections have effectively been cut by 14 cents per share.

The other problem is the ongoing lack of visibility. Jim Ryan, CEO of Grainger (GWW), bluntly said last month that he has “not seen an indication of an economic turnaround.” If the economy is improving, surely Grainger would know, wouldn’t it?

But, for the sake of argument, let’s say Mr. Ryan was just being too conservative. After factoring in the 7-cent second-quarter earnings beat, full-year forecasts have been raised by a total of 6 cents, to $5 per share, or 1.2%. A company can increase earnings by 1% simply by watching costs.

Again, I ask, why aren’t profit forecasts higher?

Look, I don’t mean to rain on anybody’s parade. I love seeing stock market rallies. The economy is moving towards stabilization. And there are some companies with truly positive earnings estimate revisions, such as Texas Instruments (TXN).

But for many months, conventional wisdom has held that the economy will start to show growth in the second-half of the year. In other words, we’re getting the economic data that we more or less expected.

The question then becomes, what’s next? Housing foreclosures probably haven’t peaked, credit card defaults are on the rise and unemployment will get worse. Not to mention that commercial real estate may have yet to hit a bottom. Under such a scenario, it only seems logical that CFOs will remain conservative with their budgets.

In other words, we’re headed for the period of slow growth that we’ve long expected. It’s the not the stuff that rallies are made of. Rather, it favors a prolonged trading range.

So enjoy the rally while it lasts, because the green shoots aren’t as widespread as the bulls would have you believe.

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