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Watch out if lofty profit expectations fall short

One of the big buzzwords this earnings-reporting season has been "surprise." But as any keen student of market history will tell you, earnings surprises are a double-edged sword.

With most of the S&P 500 companies having reported their second-quarter numbers, an impressive three-quarters of them posted profits that exceeded Wall Street analysts' consensus estimates, according to data compiled by Thomson Reuters Research. That's well above the historical norm of 62 per cent, and marks the fifth straight quarter of 70-per-cent-plus earnings beats.

Whatever the reason for those second-quarter surprises - which have lent significant support to the U.S. equity market over the summer - they are consistent with this stage of the earnings cycle. Historically, the positive-surprise counts are high as earnings are in recovery.

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But with S&P 500 earnings already approaching their peak levels of the previous cycle and with analysts' earnings forecasts for the next year looking decidedly bullish, investors may want to look for the other edge of the sword - when the profits have an increasingly tough time living up to expectations.

Rose-coloured glasses "Actual earnings tend to beat consensus estimates when the economy digs itself out of recession through the earlier stages of expansion," wrote Scotia Capital strategist Vincent Delisle. "Once the recovery is confirmed, however, and profits have forcefully rebounded, consensus estimates turn more optimistic."

Mr. Delisle believes that is now at hand: The bottom-up consensus forecast calls for S&P 500 earnings to rise about 20 per cent in 2011, to record levels.

"With signs pointing towards a slowdown in U.S. global growth in [the second half of 2010]and, more importantly, very optimistic 2011 bottom-up estimates, the stretch of positive earnings surprises will be challenged in coming quarters."

Watch the optimism deviation Mr. Delisle suggested that a key in the next 12- to 18-months will be the degree to which these lofty expectations fall short of expectations - a gap he calls "optimism deviation" (which he defines as the spread between consensus 12-month earnings forecasts and the actual results that follow).

Historically, markets can still scrape out small but respectable returns when the optimism deviation is less than 20 per cent. Based on his own top-down earnings forecast for next year, the consensus bottom-up forecast looks to be within that range - about 16 per cent, by his reckoning.

However, he said that if the U.S. economy suffers a double-dip recession, the optimism deviation could widen to more than 30 per cent. This is the key level to watch: It's where bear markets rear their ugly heads.

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