Will 2011 Earnings Set Records? Investors Would Be Wise to Doubt

As the Dow Jones Industrial Average dances around the 11,000 mark following a spate of bullish economic reports, a new optimism seems to be emerging from the depths of the Great Recession. Indeed, some are even arguing that the recession might not have been so great after all.

That may be. But other signs are flashing that the irrational despondence that set in during the grips of the downturn almost 18 months ago is now giving way to an unfounded exuberance instead. And here's the most consequential and concrete signal that Wall Street is again looking at the world through rose-colored glasses: Analysts expect S&P 500 companies to rack up enormous earnings increases next year.

Consensus analyst estimates calculated by Standard & Poor's Senior Index Analyst Howard Silverblatt now put that earnings forecast for the S&P 500 at $93.55 in 2011. Other consensus estimate calculations put the figure even higher, at about $97. That compares to about $80 for 2010, an already strong rebound following the economic collapse that hammered earnings in 2008.

Keeping Predictions in Perspective

If these estimates turns out to be true, earnings could comfortably support another 17% run-up in share prices if stocks trade at merely their historical average of about 15 times forward earnings. And stocks have commanded much higher multiples amid low interest rates in recent decades, implying that much bigger gains could be in store -- if earnings deliver in the year ahead.

But investors need to put these massive earnings growth predictions in perspective. Even at the height of the last credit-fueled boom, earnings came in at all-time high of about $88 according to some calculations. And that was amid a frenzied housing bubble, when consumers were eager to borrow against what they anticipated as perpetual gains in home prices.

The surging expectations for the year ahead suggest that Wall Street now anticipates economic activity soaring to new heights. That goes well beyond even the sharp bounce back that seemed improbable just months ago.

Of course, despite a sometimes-obsessive focus on major hurdles for the economy like high unemployment and overly indebted consumers that led to forecasts of prolonged anemic growth, overlooked pockets of strength do exist today. Major emerging-market economies are booming again, and exports could be a bigger contributor to growth. Companies are also sitting on massive stockpiles of cash.

The Perils of "Top-Down" Earnings Estimates

But Wall Street may be getting carried away by confusing a rebound and return to normalcy with the dawning of a new Golden Age. Predictions of a "new normal" with anemic growth for the foreseeable that seemed so persuasive not long ago may overstate the hurdles facing the economy. But banking on lofty new highs in corporate profits may be ignoring the long list of well-known difficulties instead.

Indeed, a "top-down" calculation of earnings expectations that focuses on macroeconomic conditions is quite different than a "bottoms up" view that synthesizes what analysts following individual companies come up with, says Silverblatt. The top-down view is looking for earnings of just $71.13. The much more frequently cited bottoms-up calculation -- one that tends to form the centerpiece of investor expectations on how to value the market -- is a startling 32% higher.

It's not unusual for analysts to get carried away in ratcheting up earnings forecasts for the companies they follow in bullish times. "From the bottoms-up view, it's always great tomorrow," Silverblatt says. Analysts poring over company financials are quicker to call turns to the upside than their more detached, big-picture peers. But "historically the top-down view has a better track record of realizing there's a problem," he says.

And that more grounded perspective will serve investors especially well as now-failed doomsday predictions quickly give way to a new bout of excessive euphoria on Wall Street.