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Profit Estimates Require Leap of Faith

Despite mounting evidence of an economic slowdown, and despite the fact that estimates for most index funds show a plausible deceleration in earnings growth vs. 2006, growth for the Russell 2000 and Nasdaq 100 (QQQQ) will supposedly accelerate if consensus estimates are to be believed.

This would be contrary to the historical performance for the Russell 2000 and Nasdaq indices; during the last downturn these two indices saw profits decline much more severely than did other benchmarks. In fact, they were the only two indices we cover to actually lose money (i.e., have negative earnings) on the whole during the years 2001-02.

We'll concede that the Nasdaq index may have been unduly penalized by the bursting of the tech bubble back then, so any downturn this time may not be as severe. But we find it implausible that iShares Russell 2000 -- which consists of the very smallest companies and in which the consumer discretionary sector accounts for nearly one third of assets -- will see earnings growth accelerate during an economic slowdown.

It isn't as if these funds are cheap, with the Nasdaq 100 trading at 23.2 times the optimistic earnings per share estimates for 2007, and iShares Russell 2000 at 21.1 times estimated 2007 EPS, compared with the S&P 500 at 14.9 times its more plausible estimates for next year.

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