Profits Climb to 51-Year Mean as S&P 500 P/E at Crisis Level
Earnings growth in the Standard & Poor’s 500 Index is climbing back to the average rate since the 1960s as the U.S. economy recovers, even with equity valuations stuck near credit-crisis levels.
Companies in the S&P 500 are poised to boost net income by 19 percent in 2011, including a 13 percent gain in the second quarter, according to analyst estimates compiled by Bloomberg. The gain will push profits back in line with their average increase of 6.9 percent over the last 51 years, data compiled by Brockhouse & Cooper Inc. and Bloomberg show. At the same time, the index is trading for 13.5 times projected 2011 earnings, 7.8 percent less than the average since the start of 2006.
The gap between earnings and shares is bolstering bulls who say equities will keep rallying as prices catch up to profits. Skeptics say reduced stimulus spending, Europe’s debt crisis and China’s efforts to curb inflation signal the 99 percent rally in the S&P 500 since March 2009 has gone too far. A report showing employers in the U.S. added 83 percent fewer jobs in June than economists projected heightened concern the economy is slowing.
“The fact that valuations have not returned to normal is simply that people are prejudiced against stocks,” said David Kelly, who helps oversee about $445 billion as chief market strategist for JPMorgan Funds in New York. “Earnings growth has been spectacular. People who are buying stocks today are buying an undervalued asset.”
Revert to Mean
Profit growth is reverting to its mean rate even as quarterly gains diminish. Projected earnings growth in the second quarter would be the slowest since the recovery began, according to data compiled by Bloomberg. It compares with a 49 percent advance in last year’s second quarter and a 29 percent contraction in the same period in 2009, the data show.
Companies that posted some of the biggest profit declines two years ago are forecast to generate gains that beat the market in the quarter ended June 30. Caterpillar Inc. (CAT), the largest maker of construction equipment, and Dow Chemical Co. (DOW), the biggest U.S. chemical maker, will probably report 63 percent and 42 percent growth, respectively, in second-quarter net income. Caterpillar posted a 66 percent decrease during the same period in 2009, while Dow reported a loss.
Stocks rose last week, pushing the S&P 500 up 0.3 percent to 1,343.80, as gains in technology and commodity companies were enough to overcome the worst monthly jobs report since September. The advance extended the equity benchmark’s 2011 gain to 6.9 percent. Since reaching a record of 1,565.15 on Oct. 9, 2007, the S&P 500 is down 14 percent.
The index dropped 1.8 percent to 1,319.49 at 4 p.m. in New York today as concern grew that Europe’s debt crisis will spread and American lawmakers failed to agree on cutting the deficit.
Alcoa Inc. (AA), the largest U.S. aluminum producer, started the second-quarter earnings season today. The New York-based company said profit more than doubled as prices for the lightweight metal rose. Excluding $38 million of one-time items, income was 32 cents a share, missing the 33-cent average analyst estimate in a Bloomberg survey.
The worst recession in seven decades caused the biggest interruption in a trend that had lifted earnings since 1960, according to Montreal-based Brockhouse, an investment consulting and securities trading firm owned by Pavilion Financial Corp. S&P 500 profits fell for nine straight quarters starting in 2007, sending annual income to a five-year low of $60.59 a share in 2008, Bloomberg data show.
The recovery since 2009 is poised to push earnings to a combined $99.34 a share this year, according to estimates compiled by Bloomberg. Reaching that forecast would almost erase the impact of the credit crisis on profits and push the rate of expansion back to its historical average, according to Brockhouse data.
“Earnings growth will continue to be positive,” said Wayne Lin, a money manager at Baltimore-based Legg Mason Inc., which manages $671 billion. “Still, there’s been a fundamental shift in psychology in terms of risk aversion after 2008. People are a lot more cautious and react a lot more quickly to uncertainty. That’s why you’re seeing attractive valuations that seem to be persistent.”
Companies in the S&P 500 are trading near the average valuation of 13.4 reached in the month after the benchmark gauge sank to a 12-year low in March 2009. Should the multiple expand to its five-year average of 14.7, the S&P 500 would climb to about 1,460 based on its 2011 projected earnings.
Fed Program Ends
Investors are refusing to pay more for future earnings because of concern the economy will slow after the Federal Reserve ended its program of buying Treasuries, according to Brian Jacobsen of San Francisco-based Wells Fargo Asset Management. While profits may be rising, growth is slowing and the economy may not support earnings at record levels, he said.
Economists’ median forecast for U.S. gross domestic product in 2011 has dropped to 2.5 percent from 2.7 percent in May, and the median for 2012 has declined to 2.9 percent from 3.1 percent, according to Bloomberg surveys. Earnings growth for S&P 500 companies may slow to 13 percent next year and 11 percent in 2013, according to estimates compiled by Bloomberg.
The S&P 500 dropped as much as 7.2 percent since reaching this year’s peak on April 29 as S&P and Moody’s Investors Service cut Greece’s credit rating.
Not Paying Up
“Valuations are still at a discount because investors don’t just pay for the next quarter’s earnings,” said Jacobsen, chief portfolio strategist for the mutual-fund division of Wells Fargo Asset Management, which oversees more than $400 billion. “They pay for the whole trajectory of earnings going into the future. Though you can be optimistic about what will be reported for the quarter that just ended, it’s hard to get too excited about growth going forward.”
U.S. Treasuries are signaling the economic slowdown will continue. The 3 percentage point gap between rates for three- month and 10-year debt indicates the economy may grow 1.1 percent in the 12 months ending June 2012, a study by the Federal Reserve Bank of Cleveland says. That’s less than half the central bank’s current forecast.
The last time S&P 500 profits exceeded their trend level, during the four years ended October 2008, the difference between earnings and the trend averaged 14.5 percent, according to Brockhouse. Should they overshoot by a similar margin this time, earnings may reach $126.80 a share by 2013, Brockhouse estimated. Analysts project $124.52 for that year, Bloomberg data show.
Caterpillar trades at 15.8 times its 2011 forecast earnings excluding some items of $6.99 a share. That compares with the average multiple of 16.4 in the past six years, Bloomberg data show. Second-quarter earnings probably climbed to $1.75, according to the average analyst estimate in a Bloomberg survey.
Dow Chemical will report 82-cents-a-share in profit excluding some items on July 27, analysts estimated. Based on its forecast 2011 earnings of $2.94 a share, the stock trades at 12.4 times earnings, 34 percent lower than its average since 2005, Bloomberg data show.
“The gap between good earnings growth and low stock valuations will close over time,” said Paul Zemsky, the New York-based head of asset allocation for ING Investment Management, which oversees $550 billion. “It’s a combination of time healing the wounds of the recession and the market putting behind the memories of the financial crisis. Profit growth will converge down to a still pretty good rate and people will move money back into stocks because they are cheap.”
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