Published: June 24, 2010

One thing was abundantly clear in the most recent earnings season: Quarterly results were often terrific as analysts had apparently underestimated the earnings strength of a wide range of companies in a wide swath of industries. And in many instances, analysts only boosted their estimates for subsequent quarters and years by a modest amount. For many, that means that more “estimate-topping” results lie in store.

But the folks that work as economists and market strategists have an entirely different view. They think that analysts are always far too optimistic, and they suspect that analysts are vastly over-estimating profits for 2011. Call it the battle of the “bottom-up” analysts versus the “top-down" strategists and economists.

It’s an important debate. The rate of actual profit growth will be the main determinant on whether investors should expect further upside or a retracement back down during the next 12 months. Everything else, from oil spills to partisan wrangling to M&A activity is just short-term noise for short-term traders.

History is on the side of the “top-down” crowd. As we have come out of recessions in the past, investors -- and the market -- have been fooled into prematurely calling for a sustainable rebound. Profit growth looks great at first, thanks to many costs cuts and revenue streams that rise back up after sinking especially low. But as revenue growth cools and cost cuts have been made, profit growth tends to fall back to earth, taking the market with it. For example, from the summer of 2001 to the summer of 2002, profits rebounded nicely, providing fresh confidence to investors. But profit gains were short-lived, and the S&P 500 ended down -22% in 2002.

So how could analysts be both overly-optimistic and also under-estimate near-term earnings strength? Simple, analysts tend to first raise forecasts after earnings estimates are exceeded, and then lower the bar again prior to the next period. That’s why it’s so important to look past companies that consistently beat estimates, and instead look for stocks that show consistently rising profit estimates during the last 90 days (which you can find on Yahoo! Finance and other financial websites).

From where I sit, the truth lies somewhere in between. Companies are now so lean that only modest sales gains will yield even higher profits. But it’s also increasingly likely that any analyst who is banking on more robust sales growth in 2011 for the companies they follow will need to ratchet down their forecasts. It’s a sad fact that many analysts derive their earnings forecasts from what management tells them. And most management teams are always blindly optimistic, acting as head cheerleader for their sales forces.

-- David Sterman
Staff Writer
StreetAuthority