The whole recent upswing was powered by lowered expectations. Now Wall Street is promising the moon. Guess what happens when they can’t deliver?

Earnings season is upon us – again. What’s the window these days, two weeks? (I mean the window when someone isn’t reporting numbers of some sort.)

Still, at least this plethora of quarterly reports allows us to focus on concrete profits for a change. Except where a lot of companies still aren’t making them. In their case, we will be treated to the usual crap: “We’re losing ground slower than we were. And we promise to lose even less money next quarter!”

The trick there is to find six guys in ties to line up and say: “We thought they should have lost more.” Than you have beaten expectations, your stock price will rise for the third quarter in a row, and your CEO will get a bonus for not totally sucking.

Guesstimates

I’ve still got those profit growth estimates from Thomson Reuters and S&P in front of me. I just find the whole stupid thing fascinating for some reason. We have very little real reason to think that genuine growth is taking place, beyond some vague statements out of Washington that the recession may have already ended, but in such a tepid fashion, no one noticed.

This would tend to make most all of these future estimates more along the lines of prayers in church than any sort of scientific process. Not “these are profits we have reason to expect,” but rather “these are the profits we have to make to keep you interested.”

But there may yet be some genuine wisdom that can be extracted from these guesstimates. By the time the final bell rings for 2009, the experts figure that profits will have fallen 16.7% year over year. And we will only get that awful number if we see 194% growth in the fourth quarter of 2009.

Talk about lighting candles and saying prayers!

That Was Bad – This Is Worse

Now keep in mind, 2008 wasn’t exactly a stellar year. But the smart guys seem to be confessing that 2009 was worse. Our reward for being awful in 2008 was a market that closed down some 37%. I suppose a drop like this is logical – we entered the year with such high expectations.

Well actually, I didn’t. I had been calling for the market to crash since at least mid summer. But I was a bit of a voice in the wilderness. Heck, it was that kind of talk that got me purged from cable TV.

Be that as it may, right now Wall Street is expecting profits to fall off some 17% Y-O-Y. But as I sit to write, shares are up 13% for the calendar year, and 54% off the March low.

Discounting Prayers

Now, I know this is not very precise. Just a bit of an intellectual exercise. But still, the gist of this is that folks bought shares in 2009 not because they were slated to make more money in 2009 (they had been told to expect even worse returns now), but because in the rosy future, companies will start making money again.

Specifically, 26.2% more money.

That’s the Y-O-Y profit gain estimate for 2010. Here’s what has me scratching my head. Stock markets look forward, right? They discount future growth. Well, it appears to me that American blue chips have already discounted about half that gain from one point of view (taking in the whole year’s growth to date).

And more than 200% of it if you figure off the March bottom.

Stranger and Stranger

Break things down by sector, and it can get even odder.

Industrials’ profits are slated to lose 34% in 2009 (if they can halve their rate of decline in the fourth quarter) and gain 13% in 2010. Shares for this group are up either 10% or 72% depending on your starting point.

If Materials companies can shift from a 69% decline in profits in Q3 to a 209% gain in profits in Q4, they will manage to close out the year down 60% Y-O-Y. Shares are up 34%-72% on a promise of 87% profit gains in 2010.

The Only Guys Making Out

In fact, there is only one segment slated to show profit gains in 2009: The Financials. You know, the guys who were all on the verge of bankruptcy five minutes ago, the ones we had to bail out at a cost of trillions of dollars to the taxpayers, because, we were assured, the very skies would fall if we did not.

Not surprisingly, these are the very same folks providing us with all the rosy profit estimates. They are looking at a 104% increase in profit in 2008. And a 71% increase in profit in 2010. And their shares are only up 20%!

If we follow this logic to its bitter end, it would seem that the only sector that is worth investing in – ever – is Wall Street itself, who makes more money when they lose than when they win.

Or something like that.

The Penalty for Raised Expectations

Okay, now I am verging on some sort of rant about leeches, which was not my intent today. Rather, I simply wanted to point out that the market has already discounted a rather remarkable turnaround in profits, which, so far, has shown absolutely no sign of actually happening. And even if we did see a modest economic turnaround (something both Justice and I have our doubts about), it would most certainly NOT justify the valuations we are already seeing in share price.

So far, this cycle has been dominated by reality beating lowered expectations. But now expectations are mighty high, and reality will certainly not be able to keep up.

What will happen to share prices? You do the math.

Other Related Topics: Earnings Report , Editor Adam Lass , Market Analysis , WaveStrength Options Weekly

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