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Party isn't over for upside earnings surprises

Over the past year and a half, the words "earnings" and "optimism" on the stock market have been like "peanut butter" and "jelly" on bread: Hard to separate. Through five straight quarters of year-over-year earnings growth, equity analysts have gotten used to seeing their increasingly generous profit estimates surpassed by the actual results.

Sooner or later, say the chronically level-headed party-poopers, the analysts are going to catch up to the earnings rally and investors' bullish expectations will creep ahead of reality. With another earnings-reporting season kicking off next week (traditional early-bird Alcoa Inc. releases its numbers Monday), might the market finally be in for a dose of earnings disappointment?

Not yet, say strategist Pierre Lapointe and economist Alex Bellefleur of Brockhouse Cooper. As rosy as analysts' estimates may be, this earnings season still has the economic cycle on its side.

Elevating estimates

In a research note this week, Mr. Lapointe and Mr. Bellefleur noted that analysts' 12-month forward earnings estimates for the MSCI World stock index - a global benchmark - have risen by 0.8 per cent over the past three months. It continues a trend of steadily rising expectations that has been in place ever since the recession ended. This is contrary to the broad historical trend; indeed, the overall average over the past 25 years shows that more often than not, analysts opt for downward revisions on a quarterly basis.

This time around, the analysts are no doubt emboldened by the optimism of the reporting companies themselves. Thomson Reuters research says the ratio of negative to positive earnings guidance announcements from S&P 500 companies is 1.8, significantly below the historical average since 1995 of 2.1.

Riding the mid-cycle

Despite the string of bullish quarterly estimates, the earnings themselves exceeded them throughout 2010 - another trend that isn't historically typical, overall.

But Mr. Lapointe and Mr. Bellefleur said that if you look at historical periods when earnings did beat consensus expectations for several quarters, they came around the middle of the earnings cycle, when growth was positive and near its peak pace, and the global economy was expanding. That fits the current circumstance and argues in favour of another quarter of upside surprises for earnings.

For further supporting evidence, the two researchers also noted that if earnings were going to disappoint, companies would be issuing guidance to steer analysts downward. Since the guidance announcements remain historically bullish, they believe the companies themselves are telling us that the analysts aren't setting up the market for disappointment this quarter.

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