Markets

Stephen Gandel is a Bloomberg Gadfly columnist covering equity markets. He was previously a deputy digital editor for Fortune and an economics blogger at Time. He has also covered finance and the housing market.

Corporate America's earnings outlook is getting dimmer, but no one on Wall Street seems to notice. That could soon be a problem.

Movin' on Up
The stock market has been on a steady climb since the end of the summer
Source: Bloomberg

According to a Bank of America Corp. monthly survey out this week, investment managers have grown considerably more bullish on corporate growth. In the October survey, 41 percent said they believe the global economy will strengthen in the next year, up from 25 percent the month before. More striking was Bank of America's "Goldilocks" expectations indicator. 

Each month, Bank of America asks fund managers to label their predictions for what growth and inflation will be in the next year as either being above-trend or below-trend. It then categorizes those opinions. Fund managers who say they are expecting above-trend growth, and below-trend inflation -- the combination of factors that many believed powered the 1990s bull market -- get put in the "Goldilocks" expectations box. A prediction of below-trend for both growth and inflation is considered to be predicting "stagnation."

In October, the percentage of fund managers predicting the Goldilocks scenario surged to 48 percent, up from as low as 10 percent back at the beginning of the year. Meanwhile, those predicting stagnation dropped to 34 percent. It was the first time the Goldilocks folks had eclipsed the stagnation predictors in more than six-and-a-half years -- and if history is any guide, it's not a good sign when this occurs or comes close to doing so.

Living the Dream
The "price-to-fantasy" gauge of stock prices relative to profit expectations suggests investors are betting that corporate profits will rise rapidly over the next two years
Source: Bloomberg
The price-to-fantasy ratio compares current stock prices to expected profits for two years into the future. Yearly price-to-fantasy ratios are based on where the ratios stood in the first week of October of each year.

Let's go back to the last time that the percentage of fund managers predicting a Goldilocks economy was higher than those calling for stagnation, in February 2011. That year, the S&P 500 index fell slightly, one of the few annual market drops in recent years. Before that,  in June 2008 -- when the percentage of Goldilocks believers came very close to exceeding stagnation predictors -- the market crashed just a few months later. In both of those prior instances, the outlook for earnings proved to be out of whack with reality, and that's arguably the case now. 

Back in July, as the third quarter began, analysts were expecting corporate profits would rise as much as 8.4 percent, according to data compiled by Bloomberg. By the end of the quarter that prediction had dropped to 6 percent. Analysts are now estimating that profits for the period only rose 3 percent. 

Step-Down
Analysts' predictions for third-quarter profit growth have slumped
Source: Bloomberg

At the same time, share prices have been soaring. The S&P 500 is up 5.5 percent since the end of June, and nearly 2 percent since the end of September alone. And there have been relatively few down days on Wall Street, despite hurricanes, political turmoil and threats of nuclear war.

Earnings growth is supposed to pick up again soon, which could be why some investors are looking past this quarter. Next year, profits for S&P 500-member companies are predicted to jump nearly 13 percent. But a number of strategists are saying that hitting that number isn't possible without some corporate tax cut. If that doesn't happen, Wall Street's "just right" consensus outlook could turn out to be wrong once again.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Stephen Gandel in New York at sgandel2@bloomberg.net

To contact the editor responsible for this story:
Beth Williams at bewilliams@bloomberg.net