Nearly a decade ago – about the time the bursting tech bubble had raised serious questions about conflicts of interest in Wall Street equity research – consulting firm McKinsey & Co. did a study on the accuracy of analysts' company earnings forecasts. The results were discouraging: Analysts were routinely over-optimistic about earnings growth, too slow to revise forecasts when economic conditions changed, and prone to increasingly inaccurate forecasts when the economy slowed.
Since then, major scandals involving tainted research have come to light, Wall Street's biggest firms have paid $1.4-billion (U.S.) in penalties for those practices, and regulators have put rules in place aimed at creating equity research with more independence and distance from the investment-banking side of the business. Unfortunately, McKinsey reports, the changes have had little effect on the accuracy of analysts' projections.
Downturn reveals same old habits
In an update of the 2001 study, McKinsey researchers found that from 2003 to 2006, analysts' earnings projections actually did look less unrealistically rosy. In each of those years, analysts, on average, actually underestimated S&P 500 annual earnings for significant portions of the year – and undershot through the entire year in 2005 and 2006.
But lest we think this was evidence of a new kind of thinking within Wall Street research departments, the Street's wide-eyed optimism came back with a vengeance starting in 2007.
Going back over the past 25 years, McKinsey found that, on average, analysts' earnings-growth forecasts “have been nearly 100-per-cent too high.” Annual S&P 500 consensus growth forecasts have typically been in the 10- to 12-per-cent range, while actual earnings growth has averaged 6 per cent.
Broken-clock accuracy
Looking at five-year rolling average growth estimates, there have only been two periods in the past 25 years when the earnings met or exceeded analysts' forecasts. Both were in recovery periods after the U.S. recessions of the early 1990s and the early 2000s.
“This pattern confirms our earlier findings that analysts typically lag behind events in revising their forecasts to reflect new economic conditions,” McKinsey researchers wrote. “When economic growth accelerates, the size of the forecast error declines; when economic growth slows, it increases.”
This pattern means that when the analysts are accurate with their forecasts, it's sort of the same way a broken clock is accurate – twice a day.
“As economic growth cycles up and down, the actual earnings S&P 500 companies report occasionally coincide with the analysts' forecasts.”
