What's another dollar

Many years ago when I was still a novice in the investment industry, I remember being party - or more correctly, an active listener to a conversation between a fund manager and a market strategist. You won't be surprised to hear that the topic of this conversation revolved around who had the more difficult job. At the crux of the fund manager's argument was that while he had to work through a raft of earnings forecasts depending on the number of companies in the fund or investable universe, the 'top-down' strategist only had to come up with one forecast - the earnings for the stock market index in question.

The problem with both scenarios is that sometimes it can take a while for the result to come through. Just like when a tossed coin hits the floor, it can bounce, spin, and roll around for a few seconds before coming to rest on one side or the other. For the economy, it takes a minimum of six months to know whether we are in a recession or not – the textbook definition of a recession is two sequential quarters of negative economic growth.

For much of 2023, that is exactly where we have found ourselves - or to use Mark Twain’s words: “rumours of a recession have been very much exaggerated”, at least, so far.

Price and earnings!

The reason for this is simple. The only thing that is known for sure is the price of a security today. Therefore, if I have strong confidence in the forecasted earnings number for a market (or a company, for that matter), I can apply what I believe is the appropriate valuation multiple to those earnings and see if the price on the screen is cheap or expensive and make my investment decision.

When it comes to forecasting the earnings for a market index, there are two methods - top-down and bottom-up. The former involves a strategist using some form of model with inputs like economic growth, monetary policy, profit margin changes, and currency movements to estimate what will be that year-on-year growth rate for the total profits of the index constituents. Whereas the bottom-up method (as the name suggests) involves aggregating up the profits of each company in the index and calculating the total profits.

Typically, at the start of each year, there is a divergence between these two numbers that slowly gets closed as the year progresses, with the bottom-up version tending to be the more optimistic from the outset. Not surprisingly, because of how the number is calculated, at the start of any year (when all those outlook documents are produced) there can also be a wide range in the top-down forecasts for earnings - different models and different assumptions ultimately mean different numbers!

Home on the range!

Again, as the year progresses, the models may not change, but greater consensus emerges on the inputs to the models and so the range of forecasts tightens - except that has not been the case so far in 2023. With over three quarters of the year behind us, the range of top-down earnings forecasts remains stubbornly wide, creating a conundrum for investors.

The mean forecast from the top-down strategists is currently pegged at close to $216. The bears are forecasting a number under $200 - with the 'Big Grizzly' at a lowly $185 - while the stomping ground for the bulls is around $250. Top or bottom, that is a $65 range for a forecast with only three months left to run! If this wide range could be justified by the 'quality' of the participants at either extreme, then some solace could be taken, but the fact is that large and venerable Wall Street doyens are present in both camps.

As I said earlier, the problem this creates for investors is that if you can't get comfort on what the 'E' will be, it makes it difficult to apply what you believe is the appropriate valuation multiple and therefore work out whether the market is currently cheap or expensive.

But this underlines one of the difficulties of top-down models. Recession-probability models (read the inverted yield curve for example) have been screaming from the rooftops that things are about to go south in a hurry since late last year. Yet rumours of the global economy's demise have, so far, been very much exaggerated. As the 'forecasted' recession gets pushed out into 2024 by some, and the degree of severity is reduced by others, not everyone on 'The Street' agrees that the glass is half-full, and potentially getting fuller.

Counting the cost?

With markets posting decent gains so far in 2023, you might ask the question - what are they waiting for? No one likes to get things wrong, of course, but on a basic level, it's a little easier to accept that you didn't call the market well when your underlying economic premise was also incorrect. But as John Maynard Keynes is often quoted "when the facts change, I change my opinion", and with less than three months to go, the window to make those changes is rapidly closing. While there will be some solace from the fact that those who chose to remain on the equity market side-lines have been 'rewarded' with good returns on their cash, in time, history might have a different view.

For now, spare a thought for those top-down strategists as few things will be more irritating to them while trying to call the economy, monetary policy, and the market, than to be told they only have one thing to worry about.