Economists are increasingly lowering their expectations for economic growth as the European saga continues and the U.S. struggles with high unemployment, weak income growth, and a fledgling housing market. Earlier this month, the Federal Reserve lowered its 2012 forecast for U.S. economic growth to a range of 2.5%-2.9% from the prior estimate of 3.3%-3.7% (issued in June). The unemployment rate is now expected to stay elevated at 8.5%-8.7% at the end of 2012, up from the prior forecast of 7.8%-8.2%. Yet despite the widespread downward revisions to economic growth, expectations for corporate earnings remain quite high for 2012 and beyond. Can US companies continue to post robust earnings growth in the face of an economy that is growing at close to stall speed?
U.S. companies have been very successful in growing their earnings from trough levels in 2009. Data from FirstCall suggests that aggregate operating earnings for the S&P 500 grew 40% in 2010, and the consensus estimate suggests earnings will grow nearly 13% in 2011. Much of the improvement in earnings can be attributed to productivity gains. Companies have been able to do more with less, as output has improved despite sharp net decreases in the employment rolls. Quarterly growth in non-farm productivity (output per worker hour) averaged +3.9% from the first quarter of 2009 to the fourth quarter of 2010. Over that same time frame, quarterly growth in unit labor costs fell 2.1%. Aggregate growth in personal income was near zero from the end of 2008 to the end of 2010, yet companies saw huge growth in their bottom lines.
The current consensus expectation for 2012 is that aggregate S&P 500 earnings will grow close to 7% -- a forecast that has not changed much despite widespread downside revisions to 2012 economic growth. In our view, this forecast may be unrealistic. Given that corporate margins are running at historical highs (which is largely the result of the productivity improvements mentioned above), it seems unlikely that margins will continue rising from here. Therefore, one would have to assume relatively robust top-line growth in 2012 even though unemployment is expected to remain high and income growth is expected to remain relatively constrained. Our view is that the consumer, who represents 70% of GDP, is undergoing a long-term process of deleveraging. This trend is best illustrated by looking at the Federal Reserve's revolving credit survey, which has declined for 32 straight months on a year-over-year basis. If the consumer is having trouble finding a job, spending less, and paying down more debt, how will companies generate the top line growth necessary for respectable income growth in 2012?
This is not to say that stocks are unattractive at today's valuations. One way to look at valuations (and therefore stock attractiveness) is to calculate a level of "normalized" earnings for the market. There are a couple of quick-and-dirty ways to do this. First, you can simply take the average of the recent peak and trough earnings for the S&P 500. The trough came in 2009 at a level of $60.80, according to FirstCall. To be conservative, we can assume the peak will come in 2011 at a level of about $96. The average of these two is around $78, putting the current P/E multiple for the market at about 16x. This is close to the long-term average.
An alternative way to calculate normalized earnings is to take the average over the past 10 years. The table below shows operating earnings for the S&P 500 over the past 10 years as published by FirstCall. The average is $72.79, putting the current P/E at 17x. This is slightly above the multiple using the peak/trough method, but in the same ballpark. Yet again, the multiple is very close to long-term averages.
The above rudimentary analysis would suggest that the market is neither over nor undervalued. However, we need to consider a couple of other factors. First, and most importantly, one must consider the available investment alternatives. In a world of 2% long-term Treasury yields, the attractiveness of stocks improves dramatically. This is especially true given that the dividend yield on the aggregate S&P 500 (at 2.1%) is higher than the long-term Treasury yield. With stocks, investors get 2.1% income, downside risk, and the potential for growth, while bond investors receive 2% income, potentially sizable losses in the event of a surge in inflation, and extremely limited upside.
The second important factor is safety. While it is true that stocks can suffer losses of 20-40% during recessions, one must consider the fact that corporate balance sheets are in better shape than they have ever been. Cash balances are at record levels, and debt balances are low. Our long-standing thesis has been that investors, including large institutional investors, will increasingly begin to appreciate the relative safety of large-cap blue chip stocks given the precarious state of many sovereign government balance sheets. There are signs we are beginning to see this rotation.
Our message is this: don't get caught up in any short-term euphoria, but also don't get discouraged. My new book The Arrogance Cycle says, "Think you can't lose? Think again!" Stocks will continue to be volatile, but long-term investors in high-quality blue chip stocks are very likely to be rewarded.