Weekly Wrap-up: Drilling Down and Fleshing Out
The following article was first published at The Agile Trader on January 29, 2007.
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Let's do two things this week: first, drill down into analysts' earnings expectations for the coming year, and then flesh out our expectations for how the market may react in this relatively longer-term time frame..
The earnings picture on the SPX remains robust. The consensus estimate for Forward 52-Week EPS on the index now stands at $96.21. (This includes our top-down estimate of 7% Y/Y growth for 1Q08.)
Trailing Operating EPS is at $87.08. Trailing Reported EPS is at $83.83. Quality of earnings also remains excellent with only a very narrow gap between Operating and Reported EPS.
Each of these EPS lines is roughly half-again as high as it was at its peak in late 2000. Meanwhile the SPX is about 130 points below its '00 high.
Headline EPS growth may slow going forward, however, if current trends continue. But, the internals of this deceleration may in fact be somewhat productive for the broad market.
What we see on this chart is that on a sector-by-sector basis earnings trends are constructive, especially in Financials, Health Care, Information Technology, and Telecom Services. But the most recent developments in the Oil Patch suggest that there may be some give-back in that sector.
Projected trends for the coming 52 weeks show Energy as the only sector with significantly below-trend EPS growth.
The problem persists, however, as to just how 8 of 10 SPX sectors will enjoy EPS growth well above the long-term market trend (+7%), with SPX F52W EPS growth currently projected at +10.5%, when nominal GDP growth is projected to be less than 5% in '07 (2.5% real growth plus about 2.4% inflation equals 4.9% nominal GDP) and profit margins are already extremely fat.
The difficulty of this set of projections coming to fruition is illustrated in this next chart. Here's how things would have to play out in terms of Corporate Profits (with Inventory Valuation and Capital Consumption Adjustments) as a percentage of Gross Domestic Product.
As of the end of 3Q06 Profits had risen to 12.4% of GDP. That's in the 99th percentile of all prior quarters since 1947. In order for profits to rise 10.5% with GDP rising just 4.9% in the next 4 quarters profits would have to rise to 13% of GDP. And that level has been achieved or exceeded just once before in this time frame, in 4Q of 1950, which would put a 13% reading in the 99.9th percentile.
Possible. Sure. But, axiomatically unlikely.
OK so what has to happen in order for our cyclically bullish forecast to come true, complete with an SPX target of 1550-1600 by the end of this year?
Well, it's already starting to happen. The very high Equity Risk Premium (ERP) has to shrink back to more normal levels.
As of last Friday the Forward Earnings Yield on the SPX was at 6.76%. And the 10-Yr Treasury Yield (TNX) was at 4.88%.
The spread between those yields is 1.88%, which is quite wide by historical standards. Investors in the 10-Yr Treasury are willing to pay almost $21 for each dollar of risk-free bond yield while investors in the SPX are only willing to pay about $14.80 for each "risky" dollar of earnings derived from the SPX.
Since 9/11 the median ERP has been 1.99%. Historically ERP tends to be very close to ZERO.
And my projection is that during the next year (or perhaps 2 years, if the market manages to avert some sort of catastrophe between May and October '07) is that ERP will shrink down to the 1-1.5% range. (The difference between the SPX and TNX yields will shrink.)
If Forward Earnings projections slow to, say a 3% rate of growth, a year from now Forward Earnings projections for the SPX would be $99.10. Now, let's say we keep 1% in ERP in the equation and TNX is yielding 5.25%. The SPX's worth in this hypothetical case would be
$99.10 / (5.25% + 1%) = 1586...
...smack in the middle of our target zone.
Of course, no-one ever knows just how these things will play out in real time. Any and all of these variables could progress differently that I expect. But this not-particularly aggressive "soft landing" scenario uses some conservative assumptions and adds some flesh to our skeletal expectations for the year.
We'll keep triangulating these expectations with what reality brings, and adjust our forecast as the seasons roll on.
Best regards and good trading!