Commentary: Earnings forecasts may need tweaking, again

(Elvis Picardo is an independent investment strategist located in Vancouver, Canada. The opinions expressed are his own.)

By Elvis Picardo

Analysts, these days, seem to be an optimistic bunch when it comes to forecasting company earnings. On the surface, that optimism looks warranted. But put under the microscope, a number of blemishes appear that suggest estimates should be lowered further going into the second half.

I first touched on the topic of rosy profit forecasts in mid-April ("Earnings estimates too optimistic") and since then estimates for the S&P 500 companies have come down. However, the billion-dollar question still lingers - have analysts lowered their earnings estimates far enough, or will they have to take a hatchet to their forecasts yet again in the weeks ahead?

With just over half of the S&P 500 companies having reported Q2 earnings so far, there seems to be a mix of good news and bad. First, the good news. As many as two-thirds of the S&P 500 constituents that have reported so far have actually exceeded analysts' estimates, while about 20 percent have missed forecasts. Although the Technology sector has had some of the biggest upside surprises in Q2, it is the Financials group that has hogged headlines for exceeding estimates, with four of the five biggest U.S. banks beating profit forecasts (or reporting lower-than-expected losses, as in the case of Citigroup).

But now for the bad news. Corporate earnings continue to be in a declining trend, and the second quarter of 2008 would mark the fourth successive quarter that earnings have fallen in comparison with the year-earlier period. Based on analysts' "bottom-up" estimates compiled by Standard & Poor's as of July 22, Q2 earnings for the S&P 500 companies are on track for a 19 percent decline from a year ago. The general expectation for Q2 earnings about four months ago was for a mere 1 percent decline.

Last spring, analysts' estimates had projected a 6 percent drop in overall earnings for the S&P 500 in the first quarter. The eventual number: a 26 percent plunge in earnings. Also at that time, analysts were forecasting a 20 percent rebound in Q3 earnings and a 74 percent surge in Q4 profits. Those forecasts have since been ratcheted down to a 10 percent and 63 percent increase in Q3 and Q4 respectively. So expectations have been tempered, but only slightly.

The optimism for an earnings turnaround also is at odds with forecasts being issued by the companies themselves. Of the 63 companies (or about one-quarter of the S&P 500 members that have reported Q2 earnings to date) that have provided outlooks, about half expect profits to decline. Overall, these companies expect quarterly earnings to be up less than 1 percent from a year ago.

Focusing on Q2 earnings for the moment, the biggest contributor to the expected 19 percent decline in S&P 500 index earnings is the Financials group, with a massive 93 percent forecasted plunge in profits. Lower earnings are also expected for the Consumer Discretionary sector, with a forecasted decline of 24 percent, as consumers grappling with higher prices and falling asset values pare back purchases of all but the most essential items.

On the plus side, the Energy and Technology groups are forecast to post earnings growth of 19 percent and 24 percent respectively in Q2. The Telecoms group is expected to be another positive contributor, with earnings forecast to rise 29 percent. While these three groups together account for about one-third of the S&P 500 index - compared with a 15 percent weighting for the Financials group - their combined influence may still be unable to offset the drag on index earnings caused by the precipitous decline in profits for the Financials group.

Looking forward, the Financials and Energy groups are expected to be the biggest contributors to the forecast earnings turnaround in the second half of 2008. Earnings for the Financials group are forecast to increase more than five-fold in the second half of the year. The implicit assumption being made by analysts here is that profits may return to a semblance of normality from their current depressed base, after being weighed down over the past 10 months by write-downs and credit losses that are collectively approaching the half-trillion dollar mark.

Earnings for the Energy group are projected to increase 43 percent in the second half, a forecast that may prove to be too optimistic if energy prices slide on concerns of a global economic slowdown. Likewise, the 18 percent forecasted increase in earnings for the Consumer Discretionary sector also needs to be viewed with caution, given that earnings have tumbled for six straight quarters.

Overall earnings for the S&P 500 are estimated to rise about 2 percent to $83.84 this year. This would represent an improvement over last year's performance, when earnings fell 6 percent to $82.54.

However, if the second-half turnaround in earnings is not as dramatic as is currently anticipated, there is a distinct possibility that index earnings may actually decline marginally this year. Should that occur, it would mark the first back-to-back earnings decline for the S&P 500 in years, a dubious distinction that was avoided even during the savage bear market of 2000-02.