Fortune Magazine
by Geoff Colvin
December 19 2007: 10:21 AM EST
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Analysts in fantasyland

Despite years of reform, the latest numbers show that Wall Street prognosticators are every bit as deluded and inaccurate as they ever were.

By Geoff Colvin, senior editor-at-large

Stocks to sizzle in '08
Even though it's been a turbulent year on Wall Street, Fortune's Jon Birger looks ahead at the best stocks for next year.

NEW YORK (Fortune) -- Maybe Wall Street analysts are more honest and less compromised than they were pre-SarbOx, but recent events show that they're still awful at their most important job: predicting bad news. They haven't lost their habit of falling in love with the companies they cover and refusing to face unpleasant realities until everyone else has already done so. Now, eight years after they were inflating the bubble, we again have to question whether analysts do retail investors any good.

The latest evidence: Analysts have only just discovered that corporate profits in the fourth quarter aren't going to be nearly as strong as they had supposed a month or two ago. The consensus view going into the quarter was that S&P 500 profits would go up 12 percent to 15 percent, a large jump coming on top of the 20 percent rise in last year's fourth quarter. In light of the credit crunch, the housing collapse, and the towering price of oil, that forecast seemed highly - one might say insanely - optimistic. This it proved to be, but only after the quarter began did the consensus view finally lurch into the real world. Their growth forecast is now about 1.5 percent and still falling.

It has been obvious for many months that profit growth would have to slow way down simply because it couldn't continue at recent rates. Profits have been rising sharply the past few years, which makes sense after the hole they fell into in 2001 and 2002. But by early this year they had grown to 12 percent of GDP, way above their historical average of 9 percent. Analysts knew all this, and in case they didn't, various commentators (including Fortune's Shawn Tully) were insistently pointing it out. But the analysts, ever hopeful, chose to believe that U.S. companies would perform magic.

They still believe it. To see the stubbornness of Wall Street's Pollyannas, look at new data from Merrill Lynch. The firm's chief North American economist, David Rosenberg, regularly and realistically forecasts S&P 500 profit growth. He cut his 2008 forecast sharply (to zero growth) in June, even before the credit crunch. He has since cut it twice more, and it's now -3 percent.

But Merrill's analysts hold a far different view. Add up their 2008 profit growth forecasts for individual S&P companies, and you get 14 percent. In analyst-land, 2008 is going to be another knockout year, with profits yet again growing several times faster than the economy. What's more, Merrill's analysts have actually been increasing their 2008 growth forecasts in recent months. In their bizarre world the logic goes like this: Since we must now admit that 2007 profits will be much lower than we expected, and since we're still certain that 2008 will nonetheless be totally fabulous, then the percentage increases will be even bigger than we thought.

How these nonsensical situations arise is no mystery. Each analyst can accept that the future may be tough overall while still believing that the companies he or she covers are special and will beat the trend. The analysts individually think they're being reasonable, but in the aggregate, they're crazy.

It's similar to what happened in subprime mortgages in recent years or stocks in the late 1990s: Many players realized the situation wasn't sustainable but figured they were especially perceptive and would get out ahead of the pack.

In the days of the market bubble, when many analysts failed to cut their earnings estimates until the collapse was underway, we blamed their motivation. They were afraid their firm's investment-banking arm would lose business. That problem has at least been reduced by SarbOx and by fear of public scrutiny. But if analysts are still predicting fantasy earnings, who cares why? Individual investors are no better off than they were.

Not every analyst gets it wrong. It's always possible in retrospect to find some who hit bull's-eyes. The trouble is, you never know who they'll be. Of course, you may be tempted to believe that while analysts in general are poor, the ones you're relying on are special and will ... no, wait. We know how that turns out.  To top of page

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