Corporate Earnings Estimates for 2008 Defy Logic - Analysts Are Last to Embrace Reality

By: Michael_Pento

What a start for the year! The S&P 500 began with its worst initial 5 trading day performance ever, Goldman Sachs joined the chorus of those who are predicting a recession for 2008, consumer confidence sunk to a record low of 56.3 and the Markit CDX North American Investment Grade series 9 index (a measure of corporate bond default risk) climbed to 100 basis points—the widest since the index's inception four years ago.

Yet despite the empirically obvious warning signs the economy is flashing, earnings estimates for 2008 still defy logic. According to Thompson Financial estimates, operating earnings for the Standard & Poor's 500 will be $102.43 this year. That's an increase of 16.27% over last year's earnings performance of $88.09. So is it logical to conclude that the market can provide an increase of that magnitude in earnings growth under these difficult conditions? I think not, and I believe history is on my side.

My hypothesis is twofold; that earnings growth estimates must retract significantly and negative earnings growth should yield negative returns for the averages during all of 2008. The market is now trading at 15.7 times last year's operating earnings. That's about the average over the past 80 years. If I'm correct that the U.S. will enter either a shallow or growth recession (G.D.P. growth around 1% or two consecutive quarters of negative GDP growth), we should not expect double digit earnings growth or a healthy stock market.

During the last recession in 2001--which was very shallow compared to historical standards--we see only three quarters of negative growth and a cumulative output decline of just 1%. By the end of 2001, GDP had recovered to pre-recessionary levels. The following chart compares the S&P 500 earnings forecast to the actual growth levels during 2001.

Year 2001     Y.O.Y. Earnings Forcast     Actual Earnings Growth

Q1                            5.3%                                       -6.1%

Q2                           -6.3%                                      -17.0%

Q3                           -6.2%                                      -21.6%

Q4                           -8.2%                                      -21.5%

Source: Thomson First Call; FDIC

If I'm correct about slow or slightly negative GDP growth, we could be in for a rough ride in the coming quarters. Just a small decline of 1% of total output produced steep contractions in earnings growth. Stay on alert for analysts to sharply lower earnings estimates in the next few months. The market also had a difficult time during 2001. That year the S&P 500 lost 12.6% of its value. Given the current economic environment, it would not surprise me if both earnings growth and total stock market returns were negative for 2008. My clients will stay defensive and continue to purchase inflation hedges.

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By Michael Pento
Senior Market Strategist
Delta Global Advisors, Inc.
866-772-1198
mpento@deltaga.com
www.DeltaGlobalAdvisors.com

A 15-year industry veteran whose career began as a trader on the floor of the New York Stock Exchange, Michael Pento served as a Vice President of Investments at Gunn Allen Financial before joining Delta Global. Previously, he managed individual portfolios as a Vice President for First Montauk Securities, where he focused on options management and advanced yield-enhancing strategies to increase portfolio returns. He is also a published theorist in the field of Austrian economics.

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