Conclusion: This market is as cheap as consensus wants it to be – if you use the wrong forward EPS assumptions.
Position: Zero Percent US Equity Allocation.
When stocks get tagged like they are today, the fall back for equity investors is to point to valuation as a reason to remain positive on the outlook for equities. While this can have credence at times, whether equities are truly a good value depends on the reliability of the forward earnings projection.
Currently, the S&P500 is broken from across all three of our key risk management durations, which is confirming our fundamental call for Growth Slowing on an intermediate-term basis. Although it is now morphing into consensus, we have held this contrarian view since the start of the year and both our bottom-up macro models and our top-down quantitative models continue to validate this conclusion.
Speaking to 2H11 specifically, Bloomberg Consensus (78 buy-side and sell-side institutions) forecasts for 3Q11 and 4Q11 GDP growth are still at +3.2% apiece on a QoQ SAAR basis. Our models continue to point to rates of U.S. economic growth that are half, or less, of those consensus estimates. We expect the consensus forecasts to once again be revised down intra-quarter, but to likely still be too high when it’s all said and done. If 1Q11 and 2Q11 have taught us anything about the merits of consensus growth forecasts, it’s that they are not to be trusted.
Perhaps the largest problem with consensus growth forecasts is that they are trusted. Be it corporations in their inventory planning, entrepreneurs in their plans to start businesses, consumers in their plans to lever up or spend, or bottom-up/fundamental equity investors in their EPS models, consensus estimates for U.S. GDP are pervasive throughout our economy. Given this construct, the biggest risk to this market and the U.S. economy at large remains that consensus assumptions for U.S. (and global) economic growth could continue to be way off the mark.
What if 2012 U.S. GDP growth is not in the area code of the +3% YoY rate currently forecasted by Bloomberg consensus? What if consensus’ +3.2% YoY assumption for 2013 U.S. GDP growth is equally as far off as their +3.2% YoY assumption for 2011 GDP growth has been? We would submit this scenario analysis would materially adjust the 2012 and 2013 EPS targets embedded in many bottom-up company models to the downside.
We’ve been vocal YTD on our call that the Street’s earnings assumptions are simply too rich. With an S&P 500 NTM EPS forecast $99.73, consensus is clearly expecting a rebound in U.S. economic growth in their current modeling assumptions. We arrive at this conclusion based upon the conviction we have in our call for historically overstretched U.S. corporate margins to compress on a go-forward basis. Simply put, if margins are compressing, a company needs topline growth to outpace the rate at which its operating performance is deteriorating in order to drive earnings growth. We do not see that happening.
In fact, slowing or declining GDP growth can lead to dramatically decelerating earnings. In the last decade we have seen this in spades as noted by the -21.5% decline in SP500 TTM earnings from March '01 through June '02 and -44.0% decline in S&P 500 earnings from September '07 through September '09. Going back the last thirty years, there have been five periods in which earnings for the S&P 500 broadly have declined. On average, the decline has been a peak-to-trough decline of -25%. In a scenario analysis where we assume we are entering a period in which earnings are on decline and they decline by the average of the five declining periods over the last thirty years, the implied earnings of the S&P 500 over the next twelve months is ~$74.79. Based on the current price of the S&P 500, this is a ~16.2x earnings multiple. Not exactly cheap.
With U.S. debt/GDP at 91.6% per the IMF (2010), we’d contend that consensus estimates for U.S. GDP growth over the next 2-3 years are as pollyanish as the Congressional Budget Office’s +2.9% average projected GDP growth over the next decade. Not only is the long-term trend of U.S. GDP growth over the last ten years far below that at +1.7% YoY, our 18-month-old work on the Sovereign Debt Dichotomy leads us to believe that U.S. economic growth may be more structurally impaired than not (email us for the relevant presentation materials).
Given the price action in the S&P 500, with the index crashing through its former long-term TAIL line of support (now resistance), we think the quantitative setup of this market is telling you that the above scenario analysis is now in play. Obviously Big Government Intervention in the form of additional easing out of the Fed could stand to limit any potential downside, but we’d be remiss to blindly trust our client’s hard-earned capital in the hands of the Central Planning Elite.
At a point, we think no amount of Quantitative Guessing will be powerful enough to overcome the likelihood that consensus (both buy-side and sell-side) has their 2011-13 EPS assumptions substantially off the mark. Again, the market can look as cheap as consensus wants it to look if they remain content with using the wrong denominator in their valuation studies.
Net-net, we need to do more work before explicitly making the call that both economic and earnings growth are going to come in substantially lighter than expected over the next couple of years, but, as market prices are signaling, it is a realistic possibility. And should that be the case, we’d expect the market to pay a lower multiple for that – QG3 or not.