The media does a terrible job of covering profits. Here are a few tips.
First, forget about the percentage of companies beating consensus, which is always way above 50% because companies guide estimates to a number they can beat. (Some managements get mad at analysts whose estimates are too high.) Even when profits are collapsing there are “more beats than misses.” It’s meaningless.
The real question is whether Q1 results and Q2 guidance are good enough to convince investors 2013 S&P EPS will be around $108. That’s bullish, even though it would imply profit growth of just 4%. The analysts’ Q1 bottom-up consensus is now $25.75 which should rise during earnings season (because of all those “positive surprises”) to around $26.50. If you just annualize that (multiply by four) you get to $106. But the first quarter is seasonally weak, so you need very little growth during the rest of the year to get to $108. Currently the bottom-up estimate is $111.50, so estimates can fall a bit over the next three quarters and we’d still get to $108. Investors already know analysts’ estimates are “too high,” so modest estimate cuts are not bearish.
What It Means for Stock Prices – “Valuation Levitation” to Continue
Isn’t “below normal” growth of 4% or 5% profit growth bearish for stock prices? No, not at all, because stocks are not trading on near-term profits. As I have discussed ad nauseam, we are in the middle of a “valuation levitation” where investors are gradually, belatedly, begrudgingly, unenthusiastically pricing in the reality that stocks offering 2% yield and 10% annual DPS growth are too cheap relative to cash, bonds, commodities, hedge funds, and vintage baseball cards. So PE ratios are rising. PE expansion and modest profit growth is a potent combination. If profits rise 4% and the PE rises from 13x to 15x, stock prices rise 20%.
Back to the Future—Weak Profits, Strong Stock Prices
We’ve been here before. Don’t forget that during the valuation levitation of the 1980s profits were poor. Looking at S&P 500 GAAP EPS on a rolling four-quarter basis, they peaked in the fourth quarter of 1984 at 16.64 and then, during an industrial recession caused by a super strong dollar, profits declined 13% to 14.52 by first quarter 1986. They did not hit a new high until the fourth quarter of 1987. But despite these punk profits (far worse than today), stock prices rose 48% between year-end 1984 and year-end 1987. That should scare any strategist arguing that today’s moderate profit growth will crater stock prices – especially when dividend growth is much faster than profit growth. (In Q1 dividends rose 12% yr/yr.)
The biggest risk to profits is Europe, which accounts for about 15% of S&P profits. (A precise figure does not exist.) Companies and analysts have been assuming Europe’s economy will recover in the second half, but that is looking less and less likely. Quite a few multinationals in such areas as technology, industrials, chemicals, beverages, food, healthcare, and consumer discretionary will be shaving guidance on weakness in Europe.
Stockman Psychosis—a Bullish Sign
You have to hand it to David Stockman. He has grabbed a second “15 minutes of fame.” ABC, NBC, NPR, CSPAN, Bloomberg—he is more ubiquitous than the GEICO gecko. Peddling insights like, “Let’s go back to the good old days of the 19th century, with the six-year depressions” and “Nothing bad would have happened to the U.S. economy if Goldman Sachs, Morgan Stanley, Merrill Lynch, Citigroup, AIG, and sundry giant European banks had been allowed to go bankrupt. The rest of the banking system was in fine fettle.” The eagerness of the mainstream press to ingest these pearls of wisdom shows how skeptical the public is about the sustainability of the Obama quasi-recovery. This pervasive skepticism constitutes the Wall of Worry that stock prices will climb over the next couple of years.
As an aside, Stockman equates the “stock market bubbles pumped up by the Federal Reserve” in 2000, 2007, and 2013. For the record, the PE ratio of the S&P 500 at the peak of these supposedly equivalent bubbles were 26.3x, 16.8x, and 14.8x. The 25-year average of this valuation metric is 18.1x. No matter, if the Fed is easing it must be a “bubble.”
Copyright 2013 Thomas Doerflinger. All Rights Reserved.
