According to the Merriam-Webster Online Dictionary, to extrapolate is “to project, extend or expand (known data or experience) into an area not known or experienced so as to arrive at a usually conjectural knowledge of the unknown area.” In other words, extrapolating essentially assumes that the past and present situation will continue going forward. Investors must be on constant alert not to extrapolate present trends too far into the future, or they may get surprised when their backwardly constructed view of the future turns out to be wrong due to cyclical or structural change that occurs naturally in our world.
Before the first quarter reporting season began, analysts were extremely negative on their outlook for corporate earnings based on the fallout from the global recession and the subsequent drop-off in corporate profits in recent quarters. It turns out that analysts have been right in their assessment of poor absolute numbers, but those that bet against positive equity returns during earnings season have been wrong as the earnings surprises (the difference between actual and consensus estimates) have been positive and markets have continued their upward trajectory. The bears will see this rally as a temporary smokescreen built on a weak foundation that is bound to fail. On the other hand, the bulls may be correct in believing that some of the gloom and doom baked into future earnings is overstated. In hindsight, investors should have questioned the complacency built into earnings estimates back in mid-2007. In my opinion, right now they should be questioning whether current analyst forecasts are too pessimistic due to recent trends. Caveat permabears – those who get caught overly “extrapolating” might be prone to getting hoodwinked by the consensus view again!
S&P 500 1st Quarter Earnings (approximately 90% of the index has reported as of 5/11/09)
