Stockmarkets: ’This isn’t the time to be a hero’

The equity rally has stalled as the credit crunch begins to seep through to the wider economy. And any bullishness is 'bordering on the delusional', given that a prolonged downturn is likely…

Analysts "only change their minds when there is irrefutable proof that they are wrong, and then they only change their minds very slowly", says James Montier of Socit Gnrale.

His chart (below) shows how "analysts lag reality": they have consistently been behind S&P 500 earnings' deviations from the long-term trend over the past decade.

But while analysts may have "fallen asleep at the wheel", as Montier puts it, it seems markets are starting to wake up to bad news. The equity rally has stalled as the credit crunch is evidently beginning to seep through to the wider economy.

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Electronics retailer DSG International issued its second profit warning of 2008, while Dutch conglomerate Philips warned of slowing growth in mature markets thanks to the credit crunch. In America, Wachovia, the fourth-largest bank, provided "yet more confirmation that the credit crunch will drag on and on", as Lex put it in the FT. It announced a surprise first-quarter loss and plans to raise capital as it expects defaults on mortgages and other loans to worsen now that the economy is deteriorating faster than it expected.

Industrial giant and economic bellwether General Electric, meanwhile, last Friday announced its worst quarter and first slide in quarterly profits in five years and slashed its full-year forecast. And the weakness wasn't confined to financial services; its healthcare and consumer products businesses also suffered. Shocked investors wiped 12% off the shares.

Further confirmation of the trouble in the wider economy was provided by the news that the University of Michigan consumer confidence index has slid to a 26-year low, as retail sales fell in real terms in the first quarter. This suggests that consumer spending will weaken further.

GE's results are likely to be the first of many earnings disappointments ahead. US analysts are still pencilling in a short and shallow recession. While second-half estimates for the financial sector have been slashed, forecasts for the rest of the S&P 500 have barely moved, which is ominous given GE's results. Bloomberg notes that S&P earnings are expected to rise 14% in the third quarter and 55% in the fourth, with profits to grow by 12% in 2008 as a whole.

The bullishness is "bordering on the delusional" given that a prolonged downturn is likely, says Wells Fargo's Scott Anderson. David Kostin of Goldman Sachs expects a string of disappointing results and forecasts following the first-quarter earnings season's "awful start" dashing expectations of a speedy recovery and hampering stocks; there is scope for another 15% drop in the S&P 500 in the near term.

Estimates still have some way to fall: Morgan Stanley says that in the past two recessions, annual consensus profit forecasts were eventually revised downwards by at least 30% from their original levels. This highlights the fact that given the optimistic earnings outlook, stocks aren't as cheap as they look. As Lex notes, apply the 30% downward revision scenario to the current consensus and the S&P 500's 2008 p/e jumps from 14 to 19.

It's a similar story in Europe. The earnings-downgrade cycle "is in its infancy", says Citigroup. Pan-European profits are still expected to expand by 4%-5% this year, while historically the overall earnings slide associated with a US recession has been 18%. Morgan Stanley expects a 16% earnings slide in 2008, although the full extent of the earnings recession is unlikely to kick in during the current reporting season.

In Britain, forecasts also look too high, says Citigroup, while Ernst & Young notes that UK firms issued 114 profit warnings in the first quarter, the second quarter in a row with more than 100 warnings a level not seen since the 2001 dotcom crash. Given the darkening outlook, Anderson's advice to investors that "this isn't the time to be a hero" looks well worth heeding.