EmailAnalyst estimates are for double-digit strong earnings growth over the year ahead. That level of growth is unlikely to happen. The risk to the market of lowered earnings forecasts is low, however, because the market is already pricing in an earnings collapse. Any increase in earnings will produce an increase in stock values similar to what has happened over the past year.
The Facts
Aggregate earnings for the S&P 500 for the year through the second quarter are $90.89, according to Standard and Poor's.
The S&P 500 index closed at 1177 on Friday, August 26.
That puts the earnings yield (earning/price) on the S&P 500 at a very alluring 7.7%. In a bow to convention, we will note that yield is equivalent to a trailing twelve-month price/earnings (P/E) ratio of just 12.9.
The year-ahead earnings estimate from analysts surveyed by Standard and Poor's is for an earnings increase of 16%.
The year-ahead earnings yield is 9.0% based on the above estimates, which equates to an 11.1 P/E.
Current Values Are Compelling
The earnings yield on the S&P 500 is extraordinarily large relative to current interest rates.
The solid 7.7% earnings yield compares to a meager 2.2% yield on 10-year U.S. Treasuries.
This spread of 550 basis points for a stock premium is highly unusual. Normally, stocks might have a slightly higher yield than bonds, but it is typically closer to 1%.
The high yield on stocks (low P/E) is due to fears that earnings will decline sharply due to a global recession, or another global credit crisis, this time sparked by problems in European banks.
Neither of these possibilities can be totally discounted. Nevertheless, the fears are extreme.
In a typical recession, earnings might be expected to decline 20%, perhaps even 30%. Yet, even if earnings were to decline a whopping 30% in the year ahead, the earnings yield on stocks would drop to only 5.4%. That equates to a P/E of 18.5.
That is a slightly low yield (high P/E) by historical standards, but would still be a high yield relative to the overall interest rate level (which is likely to prevail, particularly if the economy is weak enough to produce a decline in earnings).
In other words, the stock market is already priced for a recession that would drive earnings down as much as 30%.
A Cushion for Bad News
This creates a situation in which there is plenty of room for lowered earnings forecasts without much market impact.
The other day, a journalist on a major financial station asked an analyst about the low P/E and whether a decline in earnings would be necessary to push the market lower.
The analyst got the question wrong, and said that earnings estimates are too high and have to come down. His implication was that this would be enough to cause a decline for the stock market.
This is highly questionable. There is plenty of room for earnings forecasts to come down without causing a stock market decline. In fact, unless the earnings yield rises (P/E falls), any increase in earnings in the year ahead, regardless of what is now forecast, will produce an increase in the S&P 500 index.
It is the actual change in earnings, not the change in earnings forecasts, that will drive the stock market. The purported earnings expectations simply are not priced into current stock prices.
The Math
If earnings rise the forecasted 16% over the coming four quarters, and the earnings yield stays unchanged at 7.7% (or the P/E at 12.9), the S&P 500 will rise 16%. (This is tautological -- if the E goes up 16% and the P/E is unchanged, the P also has to be up 16%).
Similarly, if earnings rise even 5% and the S&P 500 P/E remains at a low 12.9, the S&P 500 index will rise 5%.
Any forecast of a decline in the S&P 500 index for the year ahead has to assume either a decline in earnings, or a sharp increase in the earnings yield (significant decline in the P/E).
For example, a forecast of a 10% drop in the S&P 500 index could occur with a 10% decline in earnings and a stable P/E of 12.9.
If earnings are simply flat, however, then a 10% decline in the S&P 500 would require a jump in the earnings yield to 8.5% (a drop in the P/E to 11.7).
Fear
There is tremendous fear incorporated into stock prices.
This fear goes beyond the reasonable expectation that U.S. economic growth will remain moderate for several more years, and that European economic growth will be stagnant.
The fear is based on the 2008 experience. Stock prices are depressed because of concerns that another credit market crisis will hit, or that Western democracies will enter an economic depression because of an inability to come to grips with their government imbalances.
If the U.S. economy continues to grow at even a moderate pace the next several years, earnings will rise. Earnings growth will be limited in part by likely lower margins and modest revenue growth. Earnings growth will be supported, however, by international exposure and modest nominal GDP growth in the U.S.
Given the low current valuations, the S&P 500 index can rise in line with any earnings growth; and over time, rise to a greater extent as fears subside and the earnings yield declines to a more normal relationship with interest rates (the P/E rises over time given continued low interest rates).
What It All Means
Third quarter earnings will start coming out in October. Before then, earnings estimates are likely to start coming down.
Those lower earnings estimates, however, will cause at most a temporary problem for the stock market.
Current estimates are for third quarter earnings growth of about 16% compared to the third quarter of 2010.
Even if those estimates are slashed to 10%, the reality of the strong underlying earnings growth will eventually overwhelm the concern over lowered estimates. This is because the market simply is not priced for the current earnings forecasts from analysts. The market is priced for far worse numbers, not the reported estimates.
If the U.S. economy manages to avoid a double-dip recession, and Europe muddles through its debt problems without precipitating a crisis for financial institutions in the U.S., continued earnings growth will lift the U.S. stock market over the years ahead.
In fact, if normalcy returns to the stock market in several years and fears subside, the P/E will expand from its current depressed level. That will provide significant upside to the market.
It all comes down to the low probability of a very high risk development such as a depression or credit crisis occurs, or whether there is a return to normalcy over the next several years.
Right now the market is pricing in a surprisingly high likelihood of the worst-case scenario. That provides considerable cushion for events such as lowered earnings forecasts, and long-term opportunity for portfolios willing to accept risk.
The S&P 500 is up 12.6% from this point last year.
It has been a choppy market and the bad news and fears have persisted virtually non-stop. U.S. economic growth is anemic. European banks and governments have serious debt issues.
This bad news and pervasive negativism are likely to continue.
The only good news seems to be the continued rise in earnings, the improvement in corporate balance sheets, and dividend increases. In the end, however, that is what will drive stock values.
An increase in earnings in the year ahead, even if below current forecasts, will produce another rise in the stock market, despite the continued obsession with the undeniably discouraging economic and political news.
