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.”

Global Economic Growth: The Rabbits and the Tortoises

In an important October 6 address on the International Monetary Fund’s (IMF’s) latest world economic outlook, Director Olivier Blanchard focused on the current recovery’s most significant development:

“The world economic recovery is proceeding, but it is an unbalanced recovery. It is sluggish in advanced countries, and it is much stronger in emerging and developing economies.”

This is a theme we first identified in our April 4, 2009 Outlook, and at the time and in subsequent Outlooks and blogs we emphasized that this unbalanced growth would have important investment consequences. Chief among these would be the rising relative attractiveness of the emerging economies’ equity markets and the stocks of multinational companies positioned to provide products and services to the mushrooming middle classes in these economies.

Mr. Blanchard’s presentation is very useful in explaining the IMF’s view of the sources of this growth imbalance, in quantifying the extent of the gap in 2010 and 2011, and in providing policy options which would help to restore a healthier balance. From an investment perspective, his analysis supports our view that this gap is based on structural factors that will likely continue, and may increase, in the foreseeable future.

According to the IMF, there are three major impediments restricting growth in the U.S. and Europe: weak consumption as households struggle to improve financial security, depressed housing markets, and credit-constraining weakness in their financial systems. The IMF’s 2010 GDP growth forecast for these countries is a modest 2.7%. In sharp contrast are many emerging economies, “where excesses were limited and the scars of the crisis are few.” For these economies as a whole, the IMF predicts 2010 GDP growth of 7.1% with emerging Asia’s surging 9.4% growth rate leading the charge.

The IMF expects even more headwinds will buffet the U.S. and Europe in 2011 as the global recovery enters a new stage. The major drivers of growth dating back to the inception of the recovery were inventory accumulation and fiscal stimulus. As the IMF sees it, “the first one is coming to a natural end and the second one is being slowly phased out.” Going forward, consumption and investment must take the lead. The problem is that consumption and investment in most advanced countries “are still weak and will remain so for some time.” The IMF concludes that GDP growth in these countries will shrink from this year’s 2.7% to 2.2% in 2011. This slowdown will be too anemic to reduce stubbornly high unemployment rates, which in 2011 are expected to be around 10% in both the U.S. and Europe. 2011 GDP growth in the emerging economies will also likely slow, yet will still be a robust 6.4%.

The downward revisions in the IMF forecast are representative of reduced consensus predictions as the economic “soft patch” in the U.S. and Europe has continued into the fourth quarter. Lowered economic growth assumptions will likely result in reduced corporate profit growth estimates as Wall Street analysts direct their attention to 2011. We will explore this subject and its impact on global common stock strategies in a future blog.

For a transcript of Mr. Blanchard’s remarks, see www.imf.org/external/np/tr/2010/tr101006.htm

Review of the Third Quarter 2010

To the surprise of many investors, global stock markets rallied powerfully during the 3rd quarter, and in the process offset the losses incurred in the first half of the year. The Standard & Poor’s 500 Index advanced 10.7% and the Dow Jones Industrials rose 10.4%. Even more impressive were the gains of 20.0% in the EEM Emerging Markets ETF (which includes China, India, and Brazil among others) and 18.1% in the EFA Developed Countries ETF (which includes Europe, Japan, and Australia among others, but excludes the U.S.). Most bond holders also enjoyed positive returns, as did investors in gold and many other commodities. Losses in the quarter were sustained by investors who were short these markets and currency traders who bet on further gains in the U.S. dollar and/or wagered against the euro.

At the beginning of the quarter, a pervasive gloom and doom had settled over the U.S. and international financial markets. The U.S. economy had hit a “soft patch,” and some highly publicized forecasters warned of a coming double-dip recession. Europe was racked with sovereign debt headaches that threatened another credit crisis and battered Euro Area financial markets. The leading emerging markets (China, India, and Brazil) grappled with inflation fears, which provoked some pundits to predict that initiatives taken by the governments and central banks to slow their overheating economies might overshoot and plunge their countries into recession. As risk aversion spread, the S&P 500 Index corrected -16% from April 23 through July 2, and some key international markets suffered even greater declines. By early July, an overwhelming majority of technical analysts in the U.S. and abroad predicted more losses to come.

The expected decline never occurred. Global stock markets rallied in July, when strong quarterly corporate profit reports once again exceeded estimates. A further batch of disappointing U.S. economic data in August, however, rekindled pessimism and reduced the advance. As September loomed, investors braced for more dismal economic news and were reminded by the financial media that September is historically the worst performing month for the U.S. stock market. One indication of the growing pessimism was that $16.53 billion flowed out of U.S. stock mutual funds in August, which came on top of a $10.45 billion net withdrawal in July (Investment Company Institute). Inflows into bond funds soared despite historically low yields. Bearish investors were emboldened: by the end of August, the New York Stock Exchange short interest (shares sold in expectation of profiting from future price declines) hit a 52 week high.

The September “stealth rally” was triggered by a surprisingly solid U.S. employment report released on September 3 and then supported by economic news that further discredited forecasts of a double-dip recession. An increase in corporate merger and acquisition activity was also encouraging. Adding to the optimism were favorable developments in Washington. Action in Congress to provide incentives for small business owners to hire workers and talk of an extension of the Bush tax cuts boosted the markets. The Federal Reserve also contributed by announcing its readiness to provide additional monetary stimulus in November. As the rally gathered steam with further gains each week, the pressure intensified on short sellers to limit their losses by buying into the market. The September rally was historic: the 8.8% jump in the S&P 500 Index marked the best performance of this often-dismal month since 1939.

The threat of a double dip recession combined with continued accommodation from the Federal Reserve to lower the yield (and raise the price) of bonds. The yield on the benchmark 10-year U.S. Treasury note fell to a near-record 2.51%, thereby continuing a decline dating back to April 5, when the yield peaked at 3.99%. This drop in yields took place even as the U.S. Treasury auctioned off a record $2.3 trillion of notes and bonds in the fiscal year ended September 30. Many companies took advantage of this opportunity to sell bonds at rock-bottom interest rates, and corporate debt was eagerly purchased by yield-hungry investors confronted with money-market funds yielding 0%. Most commodity investors prospered during the quarter. The CRB commodity price Index jumped 11% during the quarter, with spectacular surges in wheat (+30.4%), corn (+37.5%) and sugar (+48.6%). With much fanfare, gold topped $1300/oz. and closed September at $1307/oz. Notably lagging were energy prices: oil rose only 9% and natural gas fell -16.6%.

Currency fluctuations were surprising and significant. The U.S. dollar, which had risen 13.8% against a basket of currencies between January 1 and June 7, retreated 6.8% in the 3rd quarter. To the dismay of travelers planning trips to Europe, the euro ballooned 14.0% against the U.S. dollar following a 32.1% plunge from last November 25 through June 7. The continuing ascent of the Japanese yen, which rose a further 6.6% against the dollar, created consternation within the Japanese government and among investors in Japanese stocks. The government reacted by selling yen in the market in hopes of supporting exports and bolstering the slumping Japanese economy. Investors were disturbed: the meager 1.9% rise in the Tokyo Nikkei 225 stock market index during the quarter amounted to a miserable underperformance. Perhaps most noteworthy in the currency markets is what did not happen: the Chinese yuan inched up 1.3% against the dollar when many governments, especially the U.S., were demanding and expecting a sharp appreciation.