Despite the financial train wrecks of the past week, there is still a natural bias towards optimism inherent in equity markets. The desire not to miss out on a turning point repeatedly draws investors back in, particularly as obvious moments of panic have marked nadirs in the past. After the S&P 500 touched an intraday low of 1,134, down 28 per cent from last October’s high, it was not surprising to see a relief rally helped by the Federal Reserve’s intervention on Thursday. So, after the meltdown for banks, brokers and thrifts, what is the outlook for US earnings?

Fantastic, if you believe the analysts. Aggregating forecasts for operating income on a company-by-company or bottom-up basis, Standard and Poor’s data indicates that S&P 500 earnings, including financials, are expected to grow by an astounding 34 per cent in 2009, after slipping by 6 per cent this year. However, these forecasts have repeatedly proved too sanguine. In June 2007, second quarter earnings for 2008 were expected to be up 13 per cent. The reality was a decline of 29 per cent. Top-down forecasts are far less optimistic. After falling by a 10th this year, aggregate earnings are expected to improve by 1 per cent.

So the S&P 500 is either on 11 times or 20 times prospective earnings, the largest disconnect between the two approaches since 2002. Smithers & Co produces a cyclically adjusted price/earnings ratio (Cape) by calculating the trend level for earnings – defined as their 10-year average in real terms – and then compares it with the very long-term average Cape of 15. A return to trend puts the S&P 500 at 883. Considering that profits tend to overshoot on the way down, the outlook for US earnings and share prices is dim.

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