Getting It Wrong

Incorrect forecasts by brokerage analysts are contributing to the current downturn in the equity markets.

Energy, finance and technology are the three biggest components of the large-cap index, and analysts have been constantly revising their estimates on oil and banking companies. Last week's miss by Research in Motion (RIMM - Analyst Report) and cautious guidance by Oracle (ORCL - Snapshot Report) raised the possibility of technology earnings being a bit light in the second-half of the year.

The Oil Gush Keeps Getting Higher

Exploration and production companies continue to account for a disproportionate number of positive earnings estimate revisions, and if the International Energy Agency's (IEA) pronouncement proves to be correct, profits could continue rising for several years.

Regular readers of this column know that I've been pounding the table on companies within the upstream side of the oil business for quite some time, due to the trends in earnings estimate revisions.

Consider these statistics:

• Companies within the Oil & Gas-U.S Exploration and Production group have received 5x more positive estimate revisions than the analyst coverage would dictate¹.
• Out of the 220 stocks on the Zacks #1 Rank ("Strong Buy") List, more than 10% are classified in Oil & Gas-U.S Exploration and Production.

The reason for the bullishness is that oil continues to command prices far above what analysts expected, even relative to their revised forecasts. As crude becomes more expensive, oil E&P companies like Cabot Oil & Gas (COG - Analyst Report), EOG Resources (EOG - Analyst Report) and Noble Energy (NBL - Analyst Report) are able to earn more money.

According to the IEA, the bullish cycle for these companies could continue for several years. Yesterday, the agency's executive director, Nobuo Tanaka, predicted that "supply constraints, refinery limitations and continued demand growth in key emerging markets will maintain pressure in the market over the medium term".

Tanaka believes that current and planned infrastructure will not be enough to offset the rising demand from emerging markets. As a result, oil will remain expensive with any decline over the next 1-12 months being followed by a rebound.

What Is On The Banks Books?

Just as brokerage analysts have continuously been wrong about forecasting oil company profits, they have also been wrong about predicting just how much bad debt banks are going to write off this year. As a result, national and regional banks account for more than double the number of downward earnings estimate revisions they should otherwise command.

The fallout from the housing slump and adjustable rate mortgage resets is being compounded by a sluggish economy and rising energy prices. Banks are shooting themselves in the foot by lacking the proper staff to handle short sales and renegotiate terms with current borrowers.

Then there are the tightening credit standards. Home equity lines are being cut, which curtails a source of revenues. Mortgages are harder to get, which means lower origination fees. Credit card limits are being cut and interest rates are being raised simply because of what a consumer purchased with his credit card. (A story on NPR's Marketplace last night warned that buying retread tires could cause a card issuer view to a consumer as having a higher risk profile.) Very few companies view not doing business as a profitable strategy, but that is essentially the path many banks are on.

The result is a complex problem that is unlikely to face a resolution until next year.

To be fair, many banks view risk-adverse strategies as a short-term necessity. The majority of banks and thrifts don't know the extent of the write-offs they will be forced to take over the 6-12 months. As a result, it has been impossible for the brokerage analysts covering companies such as Washington Mutual (WM - Snapshot Report) or Zions Bancorp (ZION - Analyst Report) to project earnings with any accuracy.

Those who followed the Zacks Rank and paid attention to the downward revisions in earnings estimates would have avoided the large drops posted by financial stocks - and would continue to be weary of those now.

Where Is Technology Headed?

The third main component - technology - has been a mixed bag. Mobile computing, data storage and overseas business have been sources of growth. Semiconductors have struggled with an overall lack of pricing power, though the actual impact has been somewhat company specific.

The trend towards mobile computing and previous surprises created the expectation that Research in Motion would be beat fiscal first-quarter forecasts handily; instead the company missed. Given a warning from Sony Ericsson about weakening demand for mid- to high-end handsets, this may be an issue solely related to handsets. The new, lower priced iPhone could be stealing some market share and many individuals may be deciding that their current phone works just fine. Given that music, video and texting capabilities have been available on many mobile phones for quite some time, the extra benefit of a new phone is questionable.

Oracle presented a conundrum, however. The company's fiscal first-quarter guidance was fractionally below what some were expecting. Though the consensus estimate has stayed unchanged at 26 cents per share, four brokerage analysts trimmed their projections within the past seven days.

The worry is that if ORCL is cautious, will other tech firms be cautious as well? Current trends in earnings estimates are inconclusive. Full-year forecasts for Cisco Systems (CSCO - Analyst Report), Hewlett-Packard (HPQ - Analyst Report), IBM (IBM - Analyst Report) and SAP (SAP - Snapshot Report) are unchanged. For the entire technology sector, there are slightly more positive revisions than negative revisions, but the margin is not big (283 estimates revised up versus 222 estimates revised down).

We typically do not see many estimate revisions this time of year, so it would not be valid to characterize the lack of revisions as signaling uncertainty on the part of brokerage analysts. For traders looking for confirmation of a trend, however, the silence is deafening in the current market environment.

Investors need to view the silence for what it is, a non-event. A Zacks #3 Rank simply implies a stock should perform inline with the broader market over the short-term. Long-term investors will need to continue to monitor their stocks, but should not alter their weighting in technology without seeing further information first. This said, never hold onto an investment if doing so keeps you up at night.

Zacks Premium and Zacks Elite subscribers can view the Zacks Industry Rank List at http://www.zacks.com/zrank/zrank_inds.php. This interactive list allows you to see all of the companies, and their Zacks Rank, within more than 200 industries. Shown below is the Zacks Sector Rank List, which shows the trend in estimate revisions on a broader scale.

¹. Oil & Gas-U.S Exploration and Production accounts for less than 3% of all earnings estimates within the Zacks Rank universe (586 out of 22,174), but is the beneficiary of 15% of all upward estimate revisions (281 out of 1,824).

²Banks-West, Banks-Midwest, Banks-Major Regional, Banks-Southeast and Finance-Savings & Loan account for less than 6% of all earnings estimates within the Zacks Rank universe (1243 out of 22,174), but are responsible for 11.5% of all downward estimate revisions (252 out of 2088).

Charles Rotblut, CFA, is the senior market analyst for Zacks.com. He can be reached at crotblut@zacks.com.