As we look at the projected earnings for the S&P in 2009, we look at two articles that don’t paint a very positive picture. The first from Andrew Horowitz at the Disciplined Investor and the second from Bennet Sedacca of Atlantic Advisors Asset Management:
S&P 500 Earnings…Is that right?
December 31, 2008
There is an interesting battle going on. On one side is the tag-team of the Fed and the Treasury. On the other is corporate America’s ability to maintain profitability in the face of this severe downturn. Sometimes they are working together with a common goal, while other times they seem at odds.
Earnings in the sink
Last week, we talked about the potential for continued broad-market weakness as the hotshot analysts on Wall Street continue to slash earnings forecasts in line with deteriorating economic conditions. These new estimate cuts will sour sentiment, inflate P/E multiples and generally make life difficult for the bulls trying to bust the market higher out of the current range.
So now we are seeing two sides emerge to fight on the early January ring on Wall Street. In the green trunks dotted with bull faces, we have New Year optimism, government intervention, and monetary policy support. In the red trunks marked with bear faces, we have falling earnings, rising global tension, a bleak employment outlook, home price collapse and bankruptcies.
So how serious are these earnings estimate cuts? Well, according to a study late last week by Thomson Reuters, the current estimated fourth-quarter earnings growth rate on the SP 500 has just gone into negative territory at -0.9%, down from +65% in August and +0.5% last week. You can see this progression in the chart below. A majority of the decline is tired to downward estimate revisions in the financial, materials, consumer discretionary, and energy sectors.
What’s worrisome is that despite the reductions taken so far, more is on the way. Of the 10 sectors that comprise the index, the financials are still expected to be the largest contributor to fourth-quarter earnings growth. Analysts are looking for earnings of $5.3 billion versus a $16.1 billion loss last year. Without the financials, quarterly earnings for the S&P 500 would fall to -14.2%.
Within this sector, investment banks and brokerage houses are the largest contributors. Even with the myriad of Federal Reserve lending facilities that have allowed investment banks to offload decaying debt and derivative products in exchange for loans or Treasury instruments, it’s hard to see a turnaround of that magnitude happening so quickly. If it did, this would be the first quarter of profitability since mid-2007.
Banks are trying to minimize losses via cost cutting, but it’s revenue side of the picture that has been annihilated for these guys. Just last month JPMorgan Chase (JPM) closed its proprietary trading desk, greatly reducing its ability to directly profit from short-term movements in stocks, bonds and commodities. A record number of M&A deals were canceled this year, bringing a sharp decline in lucrative advisory fees for traditional investment bankers. And of course, the asset management business has been smashed; just ask investors who lost $1 billion in Goldman Sachs’ hedge funds.
As you can see, just by isolating the financials a strong case can be made for double-digit earnings declines for the S&P 500 heading into 2009. On top of this, you don’t need to do much mental jujitsu to make bearish cases for many of the other sectors as U.S. economic output likely fell off the cliff this quarter: Merrill Lynch (MER) economists are looking for fourth-quarter GDP to clock in at -6.7%, down from a -0.5% decline in the third quarter. It doesn’t get much better looking out into 2009, where the economy is expected to shrink another -3.1%.
Any way you look at it, earnings estimates still have a long way to fall as the fixed asset deleveraging ravages profit margins, and analysts are likely to remain behind the curve. Although anything can happen, we remain skeptical going into the start of the year even if begins with a bang.
size:100%;">Will Darwinism return to the markets?
family:arial;font-size:85%;" >As regular readers know, I have had a cautious, even bearish view, towards equities and credit over the past couple of years. The handwriting was on the wall and both equities and credit seemed woefully overvalued. That being said, our longstanding target for the S&P 500 of 750-800 was reached this autumn, a level that has held even in the face of awful economic news.
family:arial;font-size:85%;" >I do believe an ultimate low of 500-600 is possible, but most of the pain (in terms of price, not time) has been faced. Some people will tell you that the bad news is now ‘priced in’ for the S&P 500, but I strongly disagree.
family:arial;font-size:85%;" >According to S&P, their “top down/macro” earnings estimate for 2009 has fallen all the way to $42 per share. This is in direct contrast to the cumulative “bottom up/stock-by-stock” estimate of $70 or so from Wall Street analysts. The Wall Street folks have been overly optimistic for 20 years or more while the S&P has a habit of being on the mark as they don’t have an axe to grind.
family:arial;font-size:85%;" >My point is that while the S&P 500 has moved from nearly 1,600 to a recent 860 (a 45%+ decline) it remains at a healthy 22 times S&P’s earnings estimate for 2009. Bulls will tell you that the market is cheap because even if the $42 earnings number is correct, these are “trough” earnings or the low point for the cycle. I will concede that even if the $42 IS a trough number, the market is not cheap on any other metric, price to book, dividend yields, etc. In addition, P/E ratios based on trough estimates assume that earnings will rebound sharply once the bear market is over, but this is certainly not our outlook.
family:arial;font-size:85%;" >I must concede that the easy call, being out of stocks or underweight stocks in general, has been made. For 2009 and forward, a general call on the overall market will not be as easy, but good money can be made in company selection and sector rotation.
family:arial;font-size:85%;" >While equities in the US suffered 40% losses for 2008, corporate bonds and other credit sensitive securities got killed (some “core” fixed income managers were down as much as 25% for the year). The pity about 2008 for most investors is that they were let down by what was supposed to save them – DIVERSIFICATION. The year 2008 will be remembered as the year of the “1 beta event”, a year where there was nowhere to hide, except in Treasury notes and bonds.
family:arial;font-size:85%;" >We fully expected the “1 beta event” which explains why we were nearly void of equities (for clients that allow us to go to a 0% weighting) from April until our buy in the 750-775 area in the SP in November. While we are not close to being bullish about stocks in general or even credit in general, I believe that pockets of value are beginning to develop in some risky asset classes.
family:arial;font-size:85%;" >I also believe that we will enter a period of Darwinism where the best managed companies pick up the pieces of poorly managed companies that will likely fail. I believe that Darwinism will occur at the national, corporate, municipal and individual level.