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Will corporate earnings set a new all-time high in 2011?

We have just climbed out of the worst economic crisis in post war history, but analysts are already forecasting that next year corporate profits (ex financials) will reach new all-time highs. Global earnings are expected to rise by over 30% in 2010 and around 20% in 2011… if you believe the consensus estimates. We do not, at least not for 2011.

Analyst estimates are gathered and published by IBES (Institutional Brokers' Estimate System). They do this globally since 1987, for 45,000 companies in 70 markets! Although many individual analysts are known to make sensible forecasts for the companies they follow, the consensus estimates from all these professionals combined tend to suffer from profound over-optimism. In 8 out of 10 years, analysts have to significantly reduce their initial earnings forecasts as the year progresses and reality kicks in. In spite of this, these consensus estimates form the corner stone of most forward looking valuation techniques for equity markets. After all, what is the alternative?

Having said this, the positivism of analysts for 2010 is understandable. The global economy is gradually recovering, interest rates are still ultralow, inventories will have to be rebuilt and the comparison with the depressed earnings in 2009 is relatively easy. So the expected 32% earnings growth for 2010 may well be realised, even if revenue growth is likely to remain modest.

However, 2011 is an entirely different matter! With governments then starting to address their debt burdens (tax increases?) and central banks slowly raising interest rates, the environment may become less supportive. Also, comparisons with the higher earnings-base of 2010 will be more difficult and a much larger part of the earnings growth will be dependant on revenue growth. Revenues are only likely to be boosted if companies can clearly raise prices, a development which cannot be ruled out but which seems unlikely. After all, western bond yields do not point towards a world with clearly rising prices and inflationary pressures!

Consensus earnings forecasts have been around for about twenty years. In that period, corporate profitability (profit share of GDP) has probably seen the biggest jump in human history. This profit boom was mainly caused by five factors:

- Profits in the financial sector tripled as a share of GDP (esp. in the US)
- Average corporate tax rates declined steadily.
- Financing costs declined as interest rates fell.
-Consumption boomed, but labour costs did not, as the global labour supply grew and consumers “ate up” part of the value increase of their houses.
- Globalisation caused western companies to significantly increase the part of their profits made outside of their home market.

Of these five factors the last one is the only one which is likely to keep contributing to long term profit growth in developed markets. The other ones will be less dominant, for obvious reasons.

Where does this bring us? At the moment the more cyclical sectors are still profiting from the momentum in their profit recovery. As 2010 progresses expectations will keep rising and comparisons will get more difficult, probably leading to disappointments and a switch into more defensive sectors. For 2011 we are happy if even half of the expected 20% earnings growth is realised. Even such an outcome would still leave equity markets at fairly attractive valuations.