Is the consensus herding you towards hefty losses?

Overview

“There has been a positive start to the year for Australian corporate earnings estimates,” reported The Australian on 2 February. It quoted the head of Australian equities research at a global investment institution: “I think what’s happening here is, for the past few years we’ve all been waiting for the earnings cliff, (but it) hasn’t materialised ...”

This senior executive added: “the past six months (have) been reasonably good across corporate Australia … (This) is indicative of a stronger earning cycle than most in the market are assuming.” The Weekend Australian (24-25 February) concluded similarly: “a picture of resilience is emerging from Australia’s latest profits reporting season” (see also “Sentiment Upbeat as Earnings Season off to a Great Start,” The Weekend Australian, 17-18 February).

In most quarters, the optimistic and even ebullient tone persisted into May. The 26^th Macquarie Australia Conference (7-9 May), for example, was in its organiser’s words “a net upside conference ... The trend of net guidance increases that started last AGM season has continued and could continue into August results.”

AFR Weekend, too, detected no clouds on the horizon: “signs of the consensus belief in a soft landing, interest rate cuts and resilient growth in earnings are everywhere ... Bears who have tried to sit out the rally (since November) are looking very foolish indeed” (“Goldilocks landing? Don’t tell the bears,”25-26 May; see also “Is the ASX heading for a ‘mini melt-up’?” The Australian Financial Review, 22 May).

Yet the consensus has weakened. In particular, Macquarie Equities has suddenly reversed its stance. On the 27 May it belatedly foresaw the risk of a “downgrade cluster” ahead of the upcoming reporting season; it also warned of below-average returns or even a correction during the next 12 months.

Notwithstanding this weakening consensus, over the past 6-12 months many “analysts,” as well as journalists and the investors (including major funds managers), have at best been complacent and at worst shockingly inattentive. Presently, as a whole they’re either willfully blind or utterly delusional.

They’ve obsessed about the future course of earnings and interest rates, but ignored earnings’ past and current trajectory. The course of ASX-listed companies’ actual earnings over the past 12-18 months emphatically disproves bulls’ assertion that they’ve “avoided the earnings cliff.” Moreover, the disparity between today’s actual earnings and next year’s estimates – which analysts have also disregarded – is massive. This, as well as the market’s trailing P/E ratio – which they’ve also ignored, and now ranks among the highest since the late-1930s – bode ill for future returns.

In fairness, and as The Australian noted on 23 May, UBS has “warned that Australian stocks have never been so expensive, excluding the COVID years that were supported by unprecedented stimulus, (as they are now).” Moreover, its strategist foresees a “melt-up.” The Australian added: “of course, melt-ups, characterised by rapid and sustained rise in share prices that aren’t backed by fundamental economic conditions, are usually followed by meltdowns.”

To be as clear as possible: I’m NOT saying that a correction or crash is either imminent or inevitable. Rather, I demonstrate that prospective multi-year returns are much more modest, and the downward risks to these returns are much greater, than the complacent mainstream recognises.

Attempting to foresee individual stocks’ and market indexes’ short-term movements is a mug’s game. Over intervals of less than six months, and occasionally of 12 months or more, prices and returns fluctuate essentially randomly. Hence nobody can reliably predict their short-term course.

Equally, from long series of historical data it’s possible to make logically and empirically justifiable – which is hardly the same thing as unarguable, never mind infallible – inferences about equities’ multi-year prospects.

The intelligent investor constantly asks: “what if stocks fall appreciably during the next couple of years? How would such a slump affect my overall portfolio and long-term goals? Financially and psychologically, would I cope? Would I be able to take advantage of lower prices and more attractive valuations?”

Leithner & Company’s cumulative results since 1999 derive from outperformance during the bust rather than the boom. Long-term results such as ours not only require constant caution and vigilance (“mind the downside and the upside will mind itself”); they also necessitate extensive preparation for storms during periods of fine weather. Here’s a sample:

• How we prepare for – and profit from – recessions (18 August 2023);
• How we’ve prepared for the next bust (28 November 2022);
• Recessions usually crush shares – but investors can always reduce their ravages (31 October 2022); and
• How the 60/40 portfolio outperforms (17 October 2022).

Actual (“Trailing”) versus Prospective (“Forward”) Earnings

As a first step, it’s essential that we clearly distinguish a company’s or market index’s actual (“trailing”) earnings for a past period from its prospective (“forward”) earnings for a future period. As I’ve detailed elsewhere (see, for example, How experts’ earnings forecasts harm investors, 11 July 2022), a given month’s trailing earnings quantify (1) actual earnings during the previous 12 months. As such, they’re (2) consistently and (3) strictly defined. In short, they reflect Generally Accepted Accounting Principles. As such, in colloquial terms GAAP earnings include “all the bad stuff.”

It’s unfortunate but true: except during six-monthly reporting periods (“earnings seasons”), actual earnings are of little or no interest to Australian analysts. Instead, “forward estimates” preoccupy them; specifically, “consensus forward earnings” mesmerise them. The consensus of forward earnings during a given month is the mean of analysts’ estimates of a company’s or market index’s earnings during the next 12 months.

Crucially, this consensus doesn’t attempt to foresee GAAP earnings: forward estimates routinely incorporate “good stuff” (such as one-off gains) and exclude “bad stuff” (such as allegedly temporary losses, write-downs and write-offs of assets, etc.).

Estimates of forward earnings, in short and as we’ll see, typically exceed actual earnings; as such, they reflect the laxity of these earnings’ definition as well as analysts’ overconfidence. As a result, these estimates are also inconsistent over time, transient and subjective at all times.

General Patterns and Extreme Exceptions

In Do Earnings Drive Stocks’ Returns? (22 January 2024) I asked: do actual and anticipated earnings really – as the mainstream supposes – underpin stocks’ returns? I corroborated research which demonstrates that this relationship is typically much weaker and far more erratic than experts, the media and investors as a whole believe; I also showed that the influence of dividends upon returns is much more significant than they realise (see also Dividends aren’t a bane – they’re a boon, 20 November 2023).

In particular, as determinants of short-term returns – which mostly vary randomly – I showed that short-term earnings typically don’t matter; but as determinants of long-term returns, long-term average earnings occasionally exert some influence. Even in the long term, however, earnings count much less than the crowd supposes, and far less than something that it ignores: long-term average dividends.

For the purposes of this article, the key words of the two previous paragraphs are “on average” and “typically.” Under extreme circumstances – which, I suspect, currently prevail – investors’ perceptions regarding earnings can change suddenly and dramatically. Such changes, in turn, can greatly impact returns.

What are these circumstances? First, trailing earnings are now much lower than analysts estimated 12 months ago; similarly, today’s trailing earnings are far lower than forward estimates. Second, the market’s P/E ratio has reached an unprecedented (except during the COVID-19 panic and crisis) high.

Over the next 6-12 months these extremes could persist. Ultimately, though, by their very nature extremes are unsustainable. Accordingly, during the next year either (1) trailing earnings will skyrocket (as they did from March 2021 to September 2022) or (2) analysts will belatedly revise their forward estimates sharply downwards.

This latter possibility, if it occurs, will greatly surprise – indeed, shock – most investors. It thus risks a sharp correction of prices and corresponding reduction of returns.

“Experts” Ignore Trailing Earnings – Hence Recent Key Facts Elude Them

Figure 1 plots the trailing (actual) earnings of the All Ordinaries Index over the past five years. Four points – all of which, but particularly the last of which, apparently elude the mainstream – are paramount. 

1. Before the outbreak of COVID-19, earnings were falling significantly. They sagged from a CPI-adjusted maximum of $485 in August 2019 to $408 in December; that’s a slump of 16% and an annualised rate of decrease of 48%.
2. COVID-19 dramatically accelerated this decline. The pandemic caused the shutdowns which caused earnings to collapse to a CPI-adjusted low of $105 in April 2021. That was a gut-wrenching plunge of 78% from August 2019.
3. Conversely, during the next 18 months earnings recovered everything and more of their pre-pandemic and pandemic-related losses: they skyrocketed as high as $534 in October 2022. That’s an astonishing total increase of 407%!
4. Since then, however, it’s been almost continuously downhill. Earnings have fallen almost continuously – and crashed to $301 in April 2024; that’s a dive of 44% from their post-COVID-19 maximum.

Figure 1: Trailing Earnings, All Ordinaries Index, Monthly, July 2019-May 2024

Is this plunge of trailing earnings over the past 12-18 months “indicative of a stronger earning cycle than most in the market are assuming”? Does it confirm that “a picture of resilience” emerged from Australia’s latest profit reporting season? Or that “experts” have been asleep at the wheel?

Trailing Earnings since 2006

The attention of today’s mainstream is oriented towards the short-term future (that is, the next 12 months). As a result, the medium and long-term past – and what it can tell us about the medium- and long-term future – simply doesn’t interest them.

Figure 2: Trailing Earnings, All Ordinaries Index, January 2006-May 2024

Yet their lack of interest is costly: they’re apparently unaware that CPI-adjusted trailing earnings are presently, with the exception of the collapse caused by COVID-19, lower than at any time since 2006. They’re also oblivious, it seems, to the fact that since then trailing earnings have trended downwards, and on a nominal basis they’ve flat-lined (Figure 2).

Which Consensus Estimate Counts?

During the late-1990s, the U.S. Congress enacted legislation which protected companies from liability for “forward-looking statements.” To greater or lesser extents, during the next decade other countries did likewise. As a result, CEOs commonly issue “earnings guidance” – and analysts ubiquitously estimate companies’ and markets’ forward earnings. Analysts and CEOs disgorge estimates and guidance because they believe that these predictions systematically affect shares’ prices, indexes’ levels – and hence investors’ returns. Yet these beliefs are, by and large, untrue (see in particular Everything the mainstream says about earnings is wrong, 13 March 2024).

What does it mean to beat, hit or miss the consensus estimate of earnings? The uninitiated might think that it’s a straightforward matter, but it isn’t; Tim Koller, et al. (“Avoiding the Consensus-Earnings Trap,” mckinseyquarterly.com, January 2013) clarify it.

Suppose that on 15 February 2023 X Ltd reported its actual (trailing) earnings of $2.00 per share for the year ended 31 December 2022. Also on 15 February, the consensus – that is, the average of the analysts and brokers covering the stock – estimated that X’s earnings for the year to 31 December 2023 would be $2.10. By 15 February of this year – well after the conclusion of the period in question, taking into consideration X’s half-year results but before the release of its full-year earnings – the consensus forward estimate for 31 December 2023 had fallen to $1.98. And on 15 February 2024 X reported actual earnings of $2.00 per share for the year ended 31 December 2023.

Did X Ltd’s actual earnings for CY23 exceed the consensus forward estimate? Analysts constantly revise their estimates of forward earnings for a given interval of time; and according to conventional practice, a company (or market) has beaten the consensus estimate if its actual earnings are greater than the FINAL consensus estimate – which almost always appears AFTER the period in question has ended!

Initial estimates of forward earnings are provisional – and usually change, sometimes greatly, as time passes. Accordingly, in this example X has beaten the consensus estimate, which fell 5.7% during the year, even though its trailing earnings were 4.8% less than the consensus estimate at the beginning of the year!

The Widening Chasm “the Consensus” Is Overlooking

Figure 3 plots (1) the S&P/ASX 200 Index’s trailing earnings and (2) Bloomberg’s latest-available forward estimates of its earnings since January 2007. Virtually all Australian forward earnings reference the S&P/ASX 200 rather than the All Ordinaries; moreover, these two indexes’ trailing earnings are virtually identical (R² = 0.99). Accordingly, it’s reasonable to infer that results for the S&P/ASX 200 will generalise to the All Ords.

Figure 3: Forward versus Trailing Earnings, S&P/ASX 200 Index, January 2007-May 2025

In order to render the two series directly comparable, I’ve advanced the forward earnings series 12 months. In January 2006, for example, the consensus forward estimate of the S&P/ASX 200’s earnings in January 2007 was $303. In that latter month, its actual earnings were $394; hence forward earnings underestimated actual earnings by $303 - $394 = -$91, and by -$91 ÷ $394 = 23%. Figure 3 plots these discrepancies’ dollar amounts; Figure 4 plots them in percentage terms.

At first glance, during most of the time since 2007 forward estimates haven’t deviated greatly from actual earnings. The average disparity is +11%; on average, in other words, forward estimates have overestimated actual earnings by that percentage. The biggest exception by far occurred during the COVID-19 crisis, when forward estimates overestimated actual earnings by as much as 300% (in order to improve Figure 4’s readability, I’ve truncated its “Y” (vertical) axis). The second-biggest exception is occurring now.

Figure 4: Discrepancies between Forward and Trailing Earnings, S&P/ASX 200 Index, January 2007-May 2025

The forward estimates in Figure 3 are the latest available. For months until May 2023, these are final estimates, but for succeeding months they’re subject to revision. My hunch is that they’ll undergo substantial – indeed, drastic – downward revision.

From early-2022 until early 2023, forward earnings corresponded reasonably accurately to (indeed, slightly underestimated) actual earnings. Since early-2023, however, and as we’ve seen, actual earnings have cratered – yet we now see that forward estimates have barely budged. During the most recent 12 months, actual earnings have slumped more than 36% (from $492 in May 2023 to $301 in May 2024). In sharp contrast, forward estimates have remained effectively unchanged (from $513 in May of last year to $511 in May of this year).

Moreover, the latest forward estimates are implying that next year’s earnings will fall to $438. If that’s accurate, then over the next 12 months trailing earnings must lift approximately 40% from their current level ($313). How likely is that? Far stronger boosts have occurred: most notably, adjusted for CPI they rose from $105 in April 2022 to $476 in April 2022 – that’s 353%. Yet that’s the all-time maximum by far, and unprecedented fiscal and monetary stimulus underpinned it.

Table 1: Distribution of 12-month Changes of Trailing Earnings, by Quintile, June 1937-May 2024

In long-term historical terms, a 12-month increase of trailing earnings of 40% or more is highly unlikely: in only 3.6% of the 12-month intervals since June 1937 has such a thing occurred; moreover, most of these months clustered in 2021 and 2022. More generally, in just 20% of these months have earnings risen at the rate of 11.6% or more per year (Table 1).

If a sharp rise of actual earnings during the next 12 months is highly unlikely, then the other possibility – a sharp downward revision of estimates – is much more likely.

How Much Could Markets Eventually Fall?

Figure 5, which plots the All Ordinaries Index’s price-to-earnings (“P/E”) ratio since June 1937, helps to provide one answer to this question. For the period 1937-1980 I’ve incorporated data collected by Thomas Mathews (see “The Australian Equity Market over the Past Century,” RBA Bulletin, June 2019 and Recessions usually crush shares – but investors can always reduce their ravages, 31 October 2022). From June 1937 to December 2005, the Index’s P/E averaged 13.4, and since January 2006 it’s averaged 18.0.

Figure 5: Trailing P/E Ratio, All Ordinaries Index, June 1937-May 2024

A year ago, the market’s P/E was 14.8; on 31 May, it was 26.5. This current multiple is higher than any other since 1937 except those in 2020-2021. Moreover, the most recent P/E is more than 40% above its average since 2006. In short, today’s “investors” (perhaps “speculators” is more apt) are presently paying much more per $1 of earnings ($26.50) than at any other time except the COVID-19 crisis.

How much could markets fall? Given the Index’s current earnings ($301) and assuming a P/E ratio of 18 gives us an Index of 5,418 – which implies a fall of more than 30% from its present level (ca. 8,000).

Let’s recap: in the short term, prices and returns mostly fluctuate randomly. Yet I won’t be surprised if the Index’s trailing P/E ratio falls appreciably during the next 12-24 months. Since 1937, whenever it’s reached an extreme – as it clearly now has – it’s tended subsequently and quickly to regress to its long-term mean. The lower it falls at one point in time, in other words, the more it tends to rise in the future; and the higher it rises today, the more it tends subsequently to fall tomorrow (Table 2).

Table 2: Regression of trailing P/E ratio to its mean, June 1937-May 2024

For two reasons, the bottom two rows of Table 2 should disquiet today’s complacent mainstream.

First, when the Index’s P/E reaches its top quintile (20% of monthly observations since June 1937) it subsequently (12 months later) falls to an average of less than 20. Second, after two years it falls, on average, below 17. And when it rises to or above 25, the regression is even more marked.

It’s reasonable to infer (using the figures in Table 1) that during the next year the All Ords’ actual earnings will increase at their historical median of 5.2%, and that over the next two years they’ll increase 1.052 × 1.052 = 10.7%. Given its current earnings ($301), that implies earnings two years hence will be 1.107 × $301 = $333.

A multiple of 17, should it eventuate, implies an Index of 17 × 333 = 5,661 in two years – and thus a decrease of almost 30% from its current level.

Conclusions and Implications

Today, virtually everybody – including prominent “experts” and funds managers – is apparently blissfully unaware that “forward estimates” massively exceed actual earnings. They’re also oblivious to the reality – or, at any rate, they’re keeping their concerns to themselves – that the market’s trailing P/E is now sky-high.

It's important to emphasise: these developments DON’T signal that a crash is either imminent or inevitable. They do, however, augur poorly for multi-year returns; hence the risk is high that they eventually surprise – that is, disappoint – the crowd.

Prodded by myopic experts, the herd is ignorant of the past and present because it’s trying – in vain – to glimpse the near-term future. It’s an “an article of faith among Wall Street research departments,” wrote David Dreman in Contrarian Investment Strategy (1979): “nothing is as important in the practice of security analysis as estimating the earnings outlook.” Whether for individual companies or a market Index, “forecasting (earnings) is the heart of most security analysis as it is practiced today.” More than 40 years later, in Australia as well as the U.S. and elsewhere, Dreman’s assessment remains apt.

As a result, conventional security analysis has long lacked a sound basis.

Its fatal flaw is two-fold. First, the strength and direction of the influence of earnings upon returns are so erratic that, in the short term, it averages zero. In Do earnings drive stocks’ returns? (22 January) I demonstrated this crucial point with American data; in Everything the mainstream says about earnings is wrong (13 March) I corroborated it with Australian data.

The implications are enormous. A pillar of the mainstream’s obsession about “consensus forward earnings” – namely that markets boost the shares of companies whose earnings “beat the consensus estimate” – is generally false.

Similarly, investors don’t consistently punish companies whose earnings “miss” expectations. Moreover, companies which provide earnings guidance aren’t, generally speaking, valued more highly than those which don’t; nor does their “forward guidance” typically tamp the volatility of their shares’ prices.

Mainstream security analysis suffers from a second fatal flaw: human beings – including me, you and “expert” analysts – are innately poor forecasters. Everybody occasionally gets lucky, but nobody can reliably foresee companies’ short-term earnings, stocks’ prices, markets’ levels, etc. In particular, nobody can consistently predict these variables’ turning points.

Another crucial implication: in Contrarian Investment Strategies (2011), Dreman finds that analysts’ ability to forecast earnings is so poor that it’s “impossible to distinguish growth stocks ... from average companies ... or even from also-rans.”

He therefore asks: if earnings estimates “are not (accurate) enough to weed out the also-rans from the real growth stocks, ... why (would) anyone pay enormous premiums” for alleged growth stocks? His conclusion is sensible albeit greatly understated: the consensus of expected earnings “should be viewed with some suspicion.”

For the sake of our investors’ financial health, Leithner & Company ignores (apart from our own analyses) companies’ earnings guidance, analysts’ consensus of forward earnings and the journalists who parrot them.

Those who obsess about forward earnings don’t merely err almost continuously and sometimes enormously: they also blunder systematically (see in particular How experts’ earnings forecasts harm investors, 11 July 2022). The consensus of forward earnings’ level and trend is unable to foresee corrections (and bigger events such as the Crash of 1987, GFC, etc.); but the sudden realisation that expectations have enormously outpaced reality – as it now seems they’re doing – can trigger them.

Nobody, it bears repeating, can reliably predict the future; but if you possess the right tools and use them dispassionately, you can assess risks prudently. Specifically, you can detect extremes – and at these points you can (albeit roughly) distinguish sensibly-valued from under- and over-valued markets and securities.

If you investigate energetically and are prepared to think independently you can also act pre-emptively.

Leithner & Co’s awareness of analysts’ tendency to “systematically mispredict” earnings – and our insight that essentially everything the mainstream asserts about earnings is demonstrably false – has on several occasions enabled us to anticipate and take advantage of downturns. Today might be another one of those occasions.

Conversely, those who heed the consensus have – like the supposed experts who comprise it – repeatedly been caught unawares. Consequently, they’ve repeatedly endured – and will likely continue to suffer – significant losses.

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