EPS downgrades as measured by Citi’s Earnings Revision Index (ERI) have fallen for 81 straight weeks, matching the 2008-2009 drop in the wake of the financial crisis and beating every other negative streak since 2000. But Equities are up 25% since the current streak of downgrades began in May 2012, with much of the price growth happening this year, and investors are still mostly bullish. Citi’s global strategy team sees three possible reason for the discrepancy.

While a negative ERI should be a bad sign, they’ve found a stronger correlation between a falling ERI and low returns (and vice versa). The ERI has stayed negative for 81 weeks, but it has also been relatively flat.

EPS changing v avg eri 1113

Size of EPS downgrades

The size of the downgrades has also been different. In 2008-2009 trailing EPS fell 55%, but it has stayed flat over the last year and a half. Last time negative ERI was a sign that companies were failing faster than expected, this time it’s a sign of a slower than expected recovery, which is significantly different.

But maybe the biggest difference is that valuations were quite low in May 2012. “The rally since mid-2012 has been more about cheap valuation which were already pricing in very weak EPS. In May 2012, global equities were trading at a trailing PE of 14x vs. a 40-year average of 17x. No other ERI downgrade cycle (since 2000) started with such a depressed valuation,” says the Citi report.

ERI to remain negative

Citi’s global strategy team expects the ERI to remain negative while equities continue rising for a while longer, “Consensus forecasts still seem too high at 8.5% EPS growth for 2013 vs. our top-down forecast of 7%,” they write. In a sense, both trends are reflections of broad optimism about equities, and as long as the optimism outpaces corporate performance there will be a discrepancy.

For value investors looking for stocks they can buy and hold long-term, this can’t be very promising. The cheap valuations of May 2012 are long gone, and if performance continues to fall below consensus, prices will eventually have to fall. Citi’s report was prepared by Robert Buckland, Mert Genc, Beata Manthey, Jonathan Stubbs, and Ayush Tambi.