Why earnings forecasts are too optimistic

"The profit miracle is over," says The Economist. Since 2002, earnings growth has been in double digits, but in the third quarter operating earnings slid by 8.5% year-on-year, according to Merrill Lynch.

Yet forecasters are pencilling in a "remarkably" speedy recovery. Earnings are expected to expand by 14% next year, with every single sector posting gains; in the first half, when America could be in recession, the annual rate of expansion is predicted to be 9%.

These forecasts "border on the hallucinatory", says Tim Bond of Barclays Capital, in the FT. The consensus call is for economic growth to average 1% for the next two or three quarters, and growth at this rate is historically associated with a decline in operating profits. "Equity markets are also oblivious to the severity of the credit crunch".

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A quick rebound in financial sector earnings, which comprise about 30% of the S&P 500's overall profits, is hardly realistic, given rising mortgage delinquencies, gummed-up wholesale markets and a likely increase in corporate defaults as lending and the economy slows. High profit margins are contracting as labour costs rise and pricing power falls.

Predictions for global earnings, forecast to expand by 12% in 2008, also look pretty optimistic. After all, the consensus anticipates a slowdown in the world economy. And profit margins, which tend to revert to the average, reached record peaks this year, says John Authers in the FT. Markets look set for disappointment as earnings estimates "steadily fall subject to financial gravity".