Beware of Wall Street Analysts' Rosy Views

Investors might be puzzled at Wall Street analysts' full-throated bullishness about shares of BP (BP) as a torrent of oil gushes into the Gulf of Mexico and questions about the company's very existence mount. Yet analysts' perspective on that specific company is revealing and instructive about so-called "sell side" analysts as a whole.

Largely eager to present rosy pictures of the companies they cover, those analysts have issued combined earnings estimates for the S&P 500 that are now at a record $97 for 2011. And while the case for stocks remains more compelling than seems to be in vogue right now, understandably skittish investors should brace themselves for more market mayhem when this overly optimistic scenario falls short.

Its tough to think of a more widely accepted and paraded snapshot of stock market valuations than estimates of the next year's earnings. Yet this gospel of Wall Street forecasting has a long history of missing turning points in the overall economy. "They're pretty good at anticipating earnings when the economy is expanding," veteran market observer Ed Yardeni of Yardeni Research has noted about analysts, "but they typically don't see recessions coming."

And what investors need to be cognizant of now is that what may have been a sharp bounce off depressed lows in the wake of the financial crisis is now being priced into stocks as the start of a new bull market. Corporate profits did indeed jump a sharp 19% so far in 2010 compared to the prior year, the biggest gains since 1995. But considering how hard consumers and corporations slammed on the spending brakes during the depths of the financial crisis, the bar against which those gains were being measured was appallingly low.

What's worrisome now is that analysts are banking on a further 18% overall profit increase. Those earnings are supposed to materialize in an economy facing numerous challenges both domestically and overseas, and they're supposed to eclipse the prior record profits of the credit-fueled binge in 2006 and be larger in absolute terms than the profit gains registered this year.

How Long Can the Fed Keep 0% Interest Rates?

If companies can deliver on those outsize expectations, the market may be poised for another big rally. Analysts are now expecting gains of another 27% with the S&P climbing to 1,360 by next May.

But that's pricing the market for perfection. It doesn't just ignore major drags in the spotlight like deep U.S. unemployment, a lackluster economic rebound that is so far registering 3% in the first quarter, and the general cooling in major export markets such as China and Europe. It also assumes low inflation and an easy monetary policy from the U.S. Federal Reserve as far as the eye can see. Yet the Fed's ability to keep rates perpetually low may, like corporate earnings, very well be overstated.

Those counting on the Fed's continuing generosity point to unusually tame readings on inflation from indicators like the consumer price index and producer price index. But investors should note that those often-bandied-about measures are notoriously inaccurate at describing underlying economic realities.

High-profile hedge fund manager David Einhorn recently pointed out that while health care costs account for one-sixth of GDP, they only make up one-sixteenth of the price index, while rising income and payroll taxes don't count toward inflation at all. Hawkish members of the Fed have also argued that a sagging housing market may be masking signs of inflation by overstating the effect of depressed housing costs on consumers' budgets.

"Government statistics are about the last place one should look to find inflation, as they are designed to not show much," Einhorn wrote.

Warning Signs From Abroad

Outside the peculiarities of the U.S. measurement system, though, the world is rife with signs of inflation and monetary tightening. Inflation in the U.K., an economy with many structural similarities to the U.S., is already clocking twice the officially acceptable level at 3.7%.

Canada became the first G8 country to hike rates in the aftermath of the credit crisis on Tuesday. The European Central Bank may be on its way to mopping up record liquidity as soon as July, according to reports that surfaced Wednesday, well ahead of what many market participants have been anticipating. The Paris-based Organization for Economic Coordinating and Development, meanwhile, is now advocating hawkish inflation policies.

If sentiment sours amid lackluster earnings and rising inflation expectations, investors should anticipate another mood swing from Wall Street. What's now being heralded as a Goldilocks recovery could start looking more like 1970s-style stagflation.

But investors should remain more levelheaded about the case for stocks. They have many benefits, including strong growth over time, and serve as a hedge against inflation. Dealing with gyrating expectations, meanwhile, should be accepted as part of the territory.