US EQUITIES: WHERE IS THE BOTTOM?

Equity prices = Earnings per Share x Price/Earnings ratio. A 2-parts analysis trying, firstly, to estimate S&P; 500 earnings for 2009 and 2010 and, secondly, what is an appropriate valuation level for US equities currently and looking forward.

Today: EARNINGS ANALYSIS ; tomorrow: VALUATION ANALYSIS

EARNINGS ANALYSIS

2009: $40-45 on S&P; 500 Index

2010: $60-65

Goldman Sachs wisely splits the S&P; 500 eps between Financials and Non-Financials, estimating eps of $63 and $71 for 2009 and 2010 respectively under the following reasonable economic assumptions.

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The estimates for Financials assume total credit cycle-related losses of $2.1 trillion. Here is the contribution by sectors:

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Net profit margins decline to their LT average. This excludes Financials and Utilities which helps explain that margins do not decline below 5.8%. Given the severity and reach of the recession, this is a questionable forecast.

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RBC Capital Markets provide the range of possibilities under different margins assumptions.

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So, the worst case scenario is $40, the best case $60 for 2009. Given that margins normally bottom after the end of the recession, a target of 5% margins for 2009 ($40-45) appears more reasonable while a 6% margin for 2010 ($60-65) is possible.

Goldman writes:

At some point during 2009 investors will begin to disregard losses from Financials’
provisions and write-downs. We expect the stock market to trade on a pre-provision and
write-down EPS basis when we have greater clarity on Financials-related fiscal policy and
as Financials losses begin to decelerate. The reduction in the pace of Financials’ losses will
be a clear positive for the trajectory of the broader market.

How the current profit cycle compares with history

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Ex-Financials profit cycle: Profits outside the Financials sector peaked in
September of 2008, almost one year into the current economic recession, and fell
by 9% (LTM basis) in the fourth quarter. Historically, ex-Financials profits decreased
by 16% during the average profit contraction, although the past two cycles have
posted more severe declines. We estimate that ex-Financials earnings will decline by
33% in 2009 from their peak, in-line with the worst case we have seen in the past 40
years. Our forecast is an annualized estimate, suggesting the peak-to-trough decline
could be more severe when measured on a quarterly basis.

Financials profit cycle: Financials earnings declined by 166% between June 2007
and December 2008, marking the worst profit contraction for Financials during
the past 40 years. The only comparable historical period is 1987, when Financials
profits declined 109%. That profit contraction lasted nine months, and Financials
returned to record profits six months later. In the current cycle, Financials profits have
been declining for 18 months and we believe the sector will continue to lose money.
We estimate that Financials will lose less money in 2009 compared with 2008, so the
166% profit contraction will mark the peak-to-trough decline for this cycle, in our
opinion.

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When will earnings turn up? Watch the leading indicators. Here is RBC Capital Markets approach:

We continue to focus on the leading indicators to determine when the economy has passed its point of
maximum cyclical weakness. Our favorite comprehensive gauges include the ISM Manufacturing Index
and the Conference Board’s Composite Leading Economic Indicator. Both measures have generated
reliable signals at business cycle turning points for the past 48 (for the Conference Board) to 60 (in the
case of the ISM) years. An upturn in the indicators usually occurs 6-9 months ahead of an improvement
in GDP growth, 9 months ahead of corporate earnings growth and is coincident to 1-2 months behind
turns in the stock market. Equities are likely to remain at risk absent an eventual
upturn in the economy and earnings and this is why investors need to keep close watch on the leading
indicators.

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The recent small upticks in the Conference Board’s LEI in December and January provide some hope:

LEADING AND COINCIDENT INDICATORS

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