Wall Street analysts are sandbagging Q3 estimates … the S&P's CAPE ratio is nosebleed high … don't give up on this bull though … weekend homework This morning, Q3 earnings season kicked in as JPMorgan Chase & Co. (JPM) and Wells Fargo & Co. (WFC) reported their financial performance (both topped earnings forecasts). In preparation for earnings season, one week ago, analysts did their part to keep the bullish party going by lowering their earnings-per-share (EPS) estimates. It’s a simple dynamic: lower EPS estimates… which makes it easier for companies to beat those estimates… which enables Wall Street to applaud vigorously while praising the “surprisingly strong” earnings performance that keeps the buying going. Let’s jump to FactSet, which is the go-to earnings data analytics group used by the pros: Given concerns in the market about a possible economic slowdown, did analysts lower EPS estimates more than normal for S&P 500 companies for the third quarter?
The answer is yes. During the third quarter, analysts lowered EPS estimates in aggregate by a larger margin compared to recent averages.
The Q3 bottom-up EPS estimate (which is an aggregation of the median EPS estimates for Q3 for all the companies in the index) declined by 3.9% (to $60.72 from $63.20) from June 30 to September 30. Regular Digest readers aren’t surprised by this. It’s all part of the game Wall Street plays to keep the buying pressure going. How professional sandbagging works on Wall Street Buy-side analysts usually work for groups that manage money – think hedge funds and private equity groups. These buy-side analysts know that their clients will be far more forgiving of earnings estimates that are too low rather than too high. After all, if you’re an analyst whose recommendations do even better than you projected, you have a happy client – and a loyal customer who keeps paying you. But if real earnings consistently come in below your projections, your customers will likely be holding stocks that sell off in the wake of the earnings misses. This results in very unhappy clients who are likely to take their money elsewhere. So, what we see, quarter after quarter, are earnings estimates that undershoot the mark, and this way: - Earnings can miraculously beat expectations…
- Financial talking heads can boast of the “unexpected” strength of the stock market…
- And analysts can keep their gravy trains rolling.
But don’t take my word for it. A little over a year ago, FactSet ran the numbers on this, concluding: The actual earnings growth rate has exceeded the estimated earnings growth rate at the end of the quarter in 37 of the past 40 quarters for the S&P 500. The only exceptions were Q1 2020, Q3 2022, and Q4 2022… If these analysts were truly impartial, it would be impossible for them to be wrong – in just one direction – 37 out of 40 quarters. Whatever you think of this sandbagging, it sets up a continuation of today’s bull market. However, while we prepare for another bullish earnings season, be aware of what’s going on under the surface… In a perfect world, stock prices rise and fall based solely upon earnings/financial performance. After all, when you buy a stock, you’re becoming a partial owner of a company. So, the condition of its earnings should be the preeminent driver of a stock. Of course, we all know that earnings and share prices can wildly decouple… ADVERTISEMENT  The rapid advancement of artificial intelligence and automation is reshaping industries and posing threats to jobs, pushing America’s financial system to its limits. The recent Longshoremen’s Strike is just one example; we’ve also seen Hollywood actors and voice performers strike over AI-related concerns, reflecting a much larger crisis on the horizon. Click here to prepare. | Manic bullishness can result in prices that are miles above than where they deserve to trade based on earnings. Similarly, extreme bearishness can push prices to depths that in no way parallel the profits a company is generating. So, what’s happening with earnings and price today? As you can see below, since June, while EPS forecasts have been dropping (solid black line), the S&P 500’s price has been climbing (dotted blue line). 
Source: FactSet
And what do you get when you pay more to receive less? A pricey valuation. In recent Digests, we’ve highlighted a handful of valuation indicators to illustrate how expensive today’s market is For another, let’s circle back to the CAPE indicator. “CAPE” stands for “cyclically adjust price-to-earnings” ratio. It’s a long-term measure of a market’s valuation. It’s the traditional P/E ratio of a stock, but it uses rolling 10-year average earnings to smooth out business-cycle fluctuations. The CAPE ratio isn’t a market-timing tool. But it does offer investors a helpful and remarkably accurate expectation of long-term forward returns. Markets tend to revert to the mean over time, so a stock or index that has a high CAPE value today is more likely than not to see its value fall in the coming years. That would mean below-average stock returns should be expected. On the flip side, a stock or index that has a low CAPE value today is more likely than not to see its value rise in coming years. And we should expect above-average returns. The more extreme the starting CAPE value (either high or low), the more pronounced those ensuing 10-year returns often are. Below is a chart from my friend and quant investor Meb Faber, CIO of Cambria Investments. Starting in 1900, the chart shows initial CAPE values of the S&P and what the ensuing 10-year returns were after beginning at the specified CAPE value. Dark green represents the cheapest CAPE starting years (CAPEs between 5 and 10). Red represents the most expensive (CAPEs between 20 and 45). As you’ll see visually, most of the “green” starting years (low CAPE ratios) end up on the right side of the chart — meaning big 10-year returns. On the flip side, “red” starting years (high CAPE ratios) usually end up on the left side of the chart — meaning low and negative 10-year returns. 
So, what’s the S&P 500’s current CAPE value? 37.22. That’s more than double the long-term average reading of 17.16… the third-highest level in 150 years… and deep into the “red” bucket of dangerous starting valuations. 
Three quotes come to mind… From the legendary Peter Lynch in his book One Up on Wall Street: Carefully consider the price-earnings ratio. If the stock is grossly overpriced, even if everything else goes right, you won’t make any money. From Howard Marks, the co-founder and co-chairman of Oaktree Capital Management: Price has to be the starting point. It has been demonstrated time and time again that no asset is so good that it can’t become a bad investment if bought at too high a price. From the "father of value investing," Benjamin Graham: The higher the stock price relative to earnings, the greater the risk that you are paying for speculative growth, rather than solid fundamentals. What this does and does not mean… Even though this bull market officially started only about two years ago, we’re nowhere close to the historical beginning of a bull market from a traditional “low valuation” perspective. ADVERTISEMENT  Elon Musk recently warned humanity could soon be ‘obsolete.’ In fact, he went so far as to call what’s coming in the months ahead his ‘biggest fear.’ What is Musk talking about? Well, if research from The Freeport Society is correct, what Elon sees coming is something called a ‘silent invasion’ of America. In short, every port, railroad, highway, and airport in America is facilitating a kind of ‘invasion’ that could — according to one leading research firm — bring about centuries worth of change in the next few years. If Elon is right — the results could be devastating for many Americans. But if you know what’s coming and you act today — right now — you could preserve your wealth and perhaps even come out ahead with a few key moves. Charles Sizemore, chief analyst at The Freeport Society, has laid them all out in a free, short presentation. You can access everything you need to know by clicking here. | However, we could be nowhere close to this bull’s end either. Yes, the broad market is overvalued – be careful about listening to anyone arguing otherwise. But an expensive stock market can become even more expensive, making investors a boatload of money in the process. For a little perspective on this, when our bull market began a couple years ago, the CAPE reading was 28. Hardly a bargain valuation, and yet here we are. So, what do we do? The same thing we’ve been doing for many quarters at this point… We stay with this bull market until our indicators and stop-losses tell us it’s time to get out (with a focus on our specific holdings). But – importantly – we recognize what valuation suggests for where we are in this bull market. So, here’s your homework: This weekend, take a few minutes to review each holding in your portfolio. Consider… - What’s its valuation?
- Do you feel comfortable with it?
- What does it suggest about growth/mean reversion looking forward?
- Do you want to lock in any profits?
- Or is the opportunity so attractive that you’d prefer to increase your allocation?
Do whatever housekeeping you deem appropriate in light of your financial goals/investment timelines. Looking big picture, we expect this bull to continue as we look toward the end of the year… After all, sandbagging analysts are doing all they can on the earnings front… and bullish investors are doing all they can on the sentiment front. Put it together and you have the makings of higher prices. Who are we to argue? Have a good evening, Jeff Remsburg | 
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