Earlier this year, I at some research from global consulting firm McKinsey & Co., which showed that earnings forecasts among Wall Street analysts have had a lousy track record for accuracy - a nagging problem that has resurfaced through the financial crisis and economic downturn of the past few years. But those were U.S. numbers, some readers said; how do the boys and girls on Bay Street stack up?
CIBC World Markets tackled that question this week, in an illuminating report that explores analysts' earnings projections from a Canadian perspective. While the study found that Bay Street's predictions have been a valuable investing tool and have gotten considerably better in recent years, it also revealed that the analysts lose their way when the economic cycle is turning.
FOWARD BEATS BACKWARD
Senior economist Peter Buchanan discovered that over the past 50-plus years, the TSX price-to-earnings ratio based on forward 12-month earnings forecasts has been one of the better predictors of market returns over the ensuing year - in fact, vastly better than the P/E based on trailing 12-month earnings, which has been essentially useless.
And while there has been a recent trend among many market strategists to favour using "normalized" earnings for P/E valuations (i.e. average earnings over the past several years, which adjust for cyclical quirks), Mr. Buchanan found that the forward 12-month P/E proved to be just as accurate a market predictor as a cyclically adjusted 10-year-trailing P/E.
This was true despite the fact that Canadian analysts have had periods of simply dreadful earnings forecasting. From 1988 to 1991, the consensus 12-month earnings forecasts for the S&P/TSX composite index were, on average, nearly 30 per cent too high - a far bigger margin of error than S&P 500 forecasts in the U.S. Since the tech bubble burst in the early 2000s, however, Canadian earnings forecasts have vastly improved.
A U.S. OVERSHOOT?
One key finding of Mr. Buchanan's research - which was also evident in the U.S. numbers in McKinsey's study - was that Canadian analysts struggle mightily at turning points in the economic cycle. The worst overshoots in the consensus forecasts have come around recessions.
That certainly poses a dilemma for investors looking at earnings forecasts in the current economic environment - although, Mr. Buchanan argues, it would appear less so in Canada than in the United States.
In part, that's because of the healthier economic outlook for Canada. However, it also reflects the fact that U.S. analysts have been ramping up 2010 earnings growth targets in recent months even as global economic risks have multiplied, while over the same period Canadian analysts' consensus earnings forecasts have been retreating.