October 18, 2011 / 3:08 PM / 7 years ago

Analysis: Wider earnings estimates signal trouble for stocks

NEW YORK (Reuters) - Investors finally started to feel better about the stock market, just in time for earnings reports to roil expectations again.

Investors spent most of the third quarter selling shares and waiting for good news in the form of earnings that have been steady even as economic growth has been sluggish.

A possible red flag for earnings is this: The trend of narrower estimate ranges since the start of 2008 has reversed, according to Thomson Reuters data. Wider estimate ranges means analysts are collectively less sure about what will happen in coming quarters, and that uncertainty suggests underperformance.

“The worry is not really Q3, but 2012, where estimate ranges are starting to widen,” said Nick Raich, research director at Key Private Bank.

A few surprises have already hit certain stocks hard. Shares of International Business Machines Corp (IBM.N) are down more than 5 percent on Tuesday after surprisingly poor results for its third quarter.

Mean estimate ranges for the coming 12 months are wider than any point since the start of the year. Industrial stocks have not seen wider ranges from the mean since July 2010. Tech stocks have not seen as much variance in estimates since early 2010.

It could have a negative effect on stock prices. Research by Karl Diether and others at the University of Chicago and Harvard University in 2002 concluded that companies with wide estimate ranges tend to earn lower returns than otherwise similar stocks.

“When you see a widening of estimate ranges, it theoretically means you will be in for a more volatile period,” said Hank Smith, chief investment officer at Haverford Trust in Radnor, Pennsylvania, with $6.5 billion under management.

The primary reason for the widening estimates for the S&P 500 appears to be fears of a Greek debt contagion — an event that could have a broad impact on the global economy. It’s also one that analysts cannot model based on earnings and cash flows.

Analysts expect S&P 500 companies to post $107 in earnings per share in the next 12 months. But the uncertainty in the euro zone puts the range of S&P 500 earnings between $65 and $110 per share next year, according to Key Private Bank’s Raich. That’s the widest his estimates have ranged since the financial crisis of 2008.

Even consumer staples, known as a recession-resistant group, have seen wider estimate ranges. Cost pressures may be as much to blame as falling consumer sentiment, said Randy Bateman, in charge of $15 billion in assets at Huntington Private Financial Group in Columbus, Ohio.

Fund managers are at an inflection point in trying to figure out the 2012 earnings picture, said Fred Labatt, who runs about $1.8 billion at San Antonio-based South Texas Money Management. He sees the potential for more companies lowering guidance on their third-quarter conference calls.

“But I don’t really see much downside stock risk to lowered guidance — a lot of stocks already are discounting it,” he said.

The big range is one reason some strategists are encouraging more options bets that can capitalize on increased volatility, rather than just better stock selection. Markets have endured a wild time since August, judging by the CBOE Volatility Index .VIX staying at elevated levels for more than two months.

Raich said he’s been telling his derivatives team to use straddles and strangles, options trades meant to take advantage of volatility. “One way or another, the market wants to move big,” he said.

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