Wall Street sell-side analysts are historically an optimistic bunch. The group responsible for publishing research reports and setting price targets for stocks for brokerage firms and investment banks usually recommends buying most of the stocks they cover. An optimistic outlook makes a lot of sense. Most investors, by virtue of risking their money on future outcomes, are optimists.
But Wall Street analysts are now predicting something never seen before. And despite the optimism they share, it should come as a huge warning for investors.
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Long-term expectations are higher than ever
The S&P 500 (SNPINDEX: ^GSPC) has historically produced aggregate compound earnings growth of about 6.5% since 1989. Today, analysts are expecting the aggregate earnings growth for the stocks in the index to climb an average of 25.5% over the next five years. That’s the highest level ever recorded dating back to 1995.
That optimism may reflect the belief that artificial intelligence (AI) will be a transformative technology that will massively increase productivity for businesses. We saw a similar phenomenon among analysts at the height of the dot-com bubble, as the proliferation of the World Wide Web held similar promises for businesses.
Optimism about earnings growth has also led to a record number of buy ratings among S&P 500 companies. Of all analyst ratings among S&P 500 companies, 59.5% were categorized as buys as of the end of May, according to FactSet Insight. That’s the highest level on record dating back to 2010.
Analysts were issuing more buy ratings in the run-up to and at the peak of the dot-com bubble. However, they had less incentive to assign anything other than a buy rating to a stock they covered until new regulations in 2002 required the disclosure of ratings distributions. Still, it’s worth noting that buy ratings peaked around mid-2000 along with the dot-com bubble.
Indeed, we saw similar peaks in buy ratings and long-term earnings growth expectations ahead of bear markets in 2018 and 2022. And it’s possible we’re witnessing another. Investment manager Tobias Carlisle points out that analysts’ five-year earnings growth estimate is almost always wrong. “It’s a sentiment indicator, not a forecast you should trust. Analysts are notoriously bad at five-year earnings projections, and the estimates tend to be most wrong precisely when they’re most extreme.”
Be fearful when others are greedy
Just because analysts are more optimistic about the S&P 500 than they’ve seemingly ever been in recent history doesn’t mean stocks can’t keep climbing from here. But investors should never forget that stocks are valued based on expectations for the future. For a stock to continue climbing higher, it must exceed those expectations and ensure that expectations continue to climb higher. That’s why it’s not uncommon to see a hot stock beat analysts’ earnings expectations in a quarterly report, yet the stock price falls anyway.
Typically, it’s much harder to beat expectations when they’re high.
This is why Warren Buffett’s simple investment strategy works so well. “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful,” Buffett wrote in his 1986 letter to shareholders. With analysts expecting record long-term earnings growth far in excess of historic averages, it’s safe to say little fear is visible on Wall Street.
That’s not to say the market can’t keep pushing stock prices higher from here. Stocks climbed more than 16% higher from when Buffett published those words in early 1987 through the third quarter of the year. Then the index crashed more than 20% in a single day in October.
While another Black Monday is unlikely, investors should focus on buying stocks of companies trading at a meaningful discount relative to expected earnings growth. That provides a significant margin of safety if those expected earnings never materialize.
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Adam Levy has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
