Tuesday, October 26, 2010

U.S. Corporate Profits and Stock Prices

Our forecast for the U.S. economy, corporate profits, and stock prices in 2011 supports a positive if cautious outlook:
  • The U.S. stock market’s rally since 3/9/09 rests on a solid foundation of rising corporate earnings.
  • The market is not currently overvalued, and there is room for a further advance if the 2011 profit expectations of market strategists and research analysts are valid.
  •  We caution that these 2011 earnings estimates underlying a further U.S. bull market advance rest on shaky economic ground. If the economic outlook deteriorates further, companies with excessive exposure to the U.S. and other developed countries may report earnings disappointments and suffer stock price declines. We recommend investors take a global perspective and emphasize markets in fast growing economies and the stocks of multinational companies in the developed countries that have strong business opportunities in these fast growing economies.
Despite an anemic, subpar economic recovery, the Standard & Poor’s 500 Index has soared 74.9% since hitting bottom on March 9, 2009. The headwinds have been and remain formidable: weak consumer spending and confidence, sky-high unemployment and underemployment, a soggy housing market flooded by foreclosures, a troubled financial system that continues to restrain credit, and a nagging fear in business circles that Washington not only can’t remedy the problems but may make matters worse. On the other hand, the roster of positives boosting the market has evidently more than offset these negatives. These include strong corporate profits, low inflation and interest rates, a very accommodative Federal Reserve policy, an attractive market valuation coming off recession lows, and the relative lack of appeal of money market funds, bonds, and real estate.
In our view, the most important ingredient in the bull market recipe has been surprisingly robust corporate earnings. According to First Call, the trailing 4-quarter earnings per share (EPS) for S&P 500 companies rose from $62.85 as of March 31, 2009 to $79.05 on September 30, 2010, which is an increase of 26%. This includes an estimated 13% gain in year-over-year profits for this year’s 3rd quarter. Bloomberg reported on October 4 that more than 70% of S&P 500 companies have exceeded the average analyst profit projection for 4 consecutive quarters, which marks the longest streak since Bloomberg began tracking corporate earnings in 1993. We are convinced that positive earnings surprises and upward revision of future earnings estimates are the most powerful catalysts in lifting stock prices. The jump in earnings also keeps the market’s valuation attractive despite the huge run up in stock prices: the P/E ratio of the S&P 500 Index based on trailing 4-quarter earnings was 15.0% on September 30, which is close to the long term norm.
The key question now is whether 2011 profits will be strong enough to sustain the bull market. Clouding our optimism is that many economists are now predicting GDP growth next year to slow from its current sluggish rate. In The Economist’s latest polling of economists (10/23/2010), the consensus trimmed its 2010 U.S. forecast to 2.6% and predicted a further slide to 2.4% in 2011. We pointed out in our October 21 blog that in early October the International Monetary Fund (IMF) issued a similar 2011 GDP slowdown to 2.2% for developed countries as a group (the U.S. Europe, Japan, Australia, et.al.). As the IMF sees it, the economic recovery over the past 15 months has been driven by fiscal stimulus and inventory accumulation, and both are coming to an end. In the future, growth will have to come from consumption and investment, which in the developed countries are weak and not expected to improve much. A possible income tax increase in the U.S. and budget austerity programs in Europe would exacerbate the already meager 2011 prospects for growth.
There are two ways to measure 2011 S&P 500 profit expectations. A top-down forecast of market strategists, based on fundamental economic and financial market assumptions, is rosy: experts canvassed by First Call foresee a 14% advance, whereas the participants in Bloomberg’s poll anticipate a 9% rise. Even more optimistic is the bottom-up aggregate outlook provided by research analysts estimating company profits: 8,500 analysts tracked by Bloomberg expect a 15% increase. It is noteworthy that these 3 EPS estimates, which range from $87.34 to $95.95, are all above the pre-recession level of $86.20 reached in 2007. Also noteworthy is Bloomberg’s assessment that the S&P 500 is currently valued at 12 times projected income for 2011, which is “the cheapest level since 1988 (excluding October 2008 to March 2009 after New York-based Lehman’s bankruptcy), relative to reported profit from the past 12 months.”
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