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Canadian and U.S. equity values are being supported by lofty and fragile assumptions about future profit growth that, if history is any judge, are unlikely to be met. Investors should expect market volatility as earnings forecasts are revised lower.

Merrill Lynch quantitative strategist Savita Subramanian is particularly concerned about overly optimistic U.S. profit expectations. Merrill's research investment committee wrote that Ms. Subramanian "maintains her year-end price target for the S&P 500 of 2,000, versus today's level. … [She] believes that expectations for earnings growth in 2017 are too high. Wall Street is forecasting EPS growth of 13.9 per cent next year, compared to our strategy team's forecast of 6.8 per cent."

The first chart below shows trailing 12-month earnings per share for the S&P 500 compared with analyst estimates for the next 12 months. Trailing earnings for the S&P 500 have been in decline since December, 2014. The most recent results are 6.6 per cent below peak levels. Forward earnings expectations are currently only 3.0 per cent below peak levels (hit Oct. 3, 2014) and a whopping 16.6 per cent higher than profits in the past year.

The second, lower chart compares the same data for Canadian equities. Similar patterns are evident – trailing S&P/TSX composite profits per share have declined 17 per cent from the peak hit in March, 2015. Analysts expect $832.55 per share in TSX profits in the next 12 months, which is 33 per cent higher than the past 12 months.

Ms. Subramanian's estimates provide a means to gauge how far markets could fall as earnings estimates are revised lower. The S&P 500 closed Friday at 2,139.16. Analysts expect earnings per share of $124.14 (U.S.) for the U.S. benchmark in the next 12 months so the index is trading at 17.2 times forward earnings (that is, the index – 2,139.16 – divided by earnings expectations of $124.14).

As mentioned, Ms. Subramanian calculates 2017 profit growth of 6.8 per cent. If we apply this a bit early, to the next 12 months, S&P 500 profits would be $113.80. Based on this assumption, the S&P 500 is not trading at 17.2 times forward earnings; it's a much more expensive 18.8 times. With $113.80 in earnings, the S&P 500 would have to fall by 8.6 per cent to trade at 17.2 times forward profits.

The strategists' 6.8-per-cent profit growth estimates are for U.S. markets, but just for comparison I applied them to the S&P/TSX composite. The domestic equity market would have to correct by 19 per cent to maintain the same forward price-earnings level (of 17.4 times) with 6.8-per-cent earnings growth in the next 12 months.

These numbers, particularly the Canadian equity market calculations, are speculative and not a prediction in any way. It remains the case, however, that analysts are inevitably optimistic about future earnings projections for their firms and, with trailing earnings continuing a downturn, investors should pay close attention to reductions in profit growth expectations.

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