Exactly a year ago we wrote a prescient post titled “Muted Expectations Could Set the Stage for a Positive Stock Market Surprise.” Analyzing Barrons’ survey of 12 equity strategists, published in early September 2012, we suggested (incorrectly) that their forecasts of S&P 500 EPS might be slightly optimistic, but (very correctly) that their PE assumptions were extremely conservative. Specifically, their year-end 2012 S&P price targets of 1425 implied a trailing PE of 13.8x and a forward PE of 13.2x.
“Wall Street’s strategists,” we noted, “are using PE assumptions that are very conservative by historical standards, particularly considering that we are in a low-inflation, low-interest rate environment. (italics in original)” We argued that a positive economic surprise, such as a Romney victory, could boost the PE of the index well above the Wall Street consensus, producing strong stock market gains. Despite Romney’s defeat, this PE expansion – which we subsequently heralded in multiple posts as “valuation levitation” — is precisely what happened. Even after the recent pull-back, the market’s trailing PE is 15.4x; at the market’s recent peak it was 16.1x.
Fast forward a year, and Street strategists have become decidedly more bullish:
- They are forecasting EPS growth in 2014 of 7.4% (median), whereas a year ago they expected 2013 EPS growth of just 5.6%, which was quite accurate.
- Four of the eleven strategists have 2014 EPS estimates of $119 or above, which is just slightly below the analyst bottom-up consensus of $123. Although analysts are not always too bullish, they probably are now; expecting the bottom-up estimate to drop just $3-4 over the next 19 months is optimistic.
- Their year-end 2013 S&P price targets imply a trailing PE of 15.7x (versus 13.8x a year ago) and a forward PE of 14.4x (versus 13.2x a year ago).
Complacency Is Setting In
I don’t have an argument with strategists’ PE assumptions, which look reasonable given still-low rates and no recession on the horizon. On the other hand, their profit expectations are optimistic. After profit growth this year of about 5.6%, they expect acceleration to 7.4% in 2014. It certainly could happen, and today’s strong ISM Manufacturing report is an important positive signpost. But profits do face multiple headwinds:
- Emerging markets are slowing sharply as Fed taper talk craters their currencies, raising their import costs and forceing them to raise rates.
- U.S. profit margins are already at historic highs.
- Notwithstanding the strong ISM, U.S. economic momentum is weak, with real personal disposable income rising a pathetic 0.8% over the past year. (By comparison, growth averaged 3.0%, 2003-2006.)
- A principal cause of weak U.S. growth, Obama’s anti-capitalist agenda, continues unabated, with ObamaCare kicking in soon, the EPA attacking coal and oil, and big banks facing a new regulatory attack every week.
- Rising interest rates should dampen the U.S. housing market at least modestly.
- Fiscal policy will remain restrictive, albeit less so than in 2013.
- China’s economy is driven in significant measure by local governments investing in grandiose projects. (Among other things, they are playing the game “my skyscraper is bigger than yours.”)
- Europe is just gradually emerging from a severe recession, and bank balance sheets are too weak to fund robust growth.
Unlike a Year Ago, Upside Surprise Is Unlikely
The views of prominent strategists are a pretty good barometer of Street sentiment. (In fact, Merrill Lynch has long used them as a contrary indicator.) Compared to last year, strategists are pretty bullish, which means that – even if they are largely correct — the chances of an upside surprise are decidedly lower than a year ago.
Copyright 2013 Thomas Doerflinger. All Rights Reserved.
