In the last few weeks neither good economic news (Q3 GDP grew 3.5% q/q annualized against consensus expectations of 3.2% q/q annualized) nor encouraging quarterly results (over 80% of the S&P 500 companies have so far beat consensus expectations – their best showing since 1993 according to Bloomberg agency’s calculations) were enough to push the S&P500 to a new 2009 high. As fears that the economy might enter a severe depression - which led the market to its lowest since 1996 in March - receded, the US stock market now appears to be increasingly more dependent on the continuation and strength of the economic recovery under way. Leaving aside short-term movements, which are mainly triggered by speculative factors, the medium-term S&P500 performance is highly reliant on corporate profits. The chart below, for example, shows that the S&P 500 and the corporate profits of its constituents have followed a similar trend over the course of the past 20 years.
Looking back at the early 1950s and considering national accounting profits after taxes and adjusted for inventory valuation and capital consumption adjustments instead of S&P500 corporate profits, results are substantially the same, though profits outperformed the S&P500 (dividend distribution is not taken into account). The only period in which profits and stock market did not move in the same direction was during the '70s, when, due to the high inflation, profits grew sharply while the S&P 500 was substantially flat (in spite of substantial price volatility), in line with the negative performance delivered by all financial assets. Therefore, investors fear a return of inflation to values more in line with those last seen in the '70s. Nevertheless, this scenario now seems to be highly unlikely despite the recent return of tips-based inflation expectations to above 2%. If the stock market trend will depend primarily on profits, an analysis of the S&P 500 outlook can only start from their future potential performance.
Standard & Poor's estimates for earnings as reported (net of write-downs of extraordinary items) for 2010 are extremely cautious: following the 197% bounce in 2009 (they slumped 77.5% in 2008), profits are expected to edge up 2.9% in 2010 but to jump 34% in 2011. Operating profits projections are much more optimistic: after gaining 12.6% in 2009 (-40% in 2008), profits are seen improving by 33% in 2010.
However, a more reliable barometer for understanding the earnings outlook of U.S. companies is the analysis of national accounting data, as it is less influenced by the budget choices of individual companies. To analyse the earnings outlook we have used two variables that have a good track record in projecting the trend in profits, as shown in the graphs below: profit margin, defined as the ratio between national accounting profits and nominal GDP, and the yield differential between 10 year and 2 year Government Bonds.
Though not nearing the 1982 recession trough, over the past two years profit margins have achieved a level usually followed by a higher average weighted earnings growth in the following 5 years than the long term average (8.4% versus 7.3%). Reassuring signals also come from the analysis of the yield curve. The steepness of the Government yield curve, with the ten-year yield 200 basis points above the 2-year yield suggests that profitability should rise sharply in the next 3 years. Therefore, positive earnings growth in the years ahead might be jeopardized only by a marked fall in nominal GDP, which should coincide with a major deflationary phase.
Although a positive earnings outlook is a good precondition for a S&P 500 uptrend going forward, investors are growing increasingly worried about the equity market valuation in the wake of the recent rally. The ratio price/average earnings of the last 10 years partially confirms these fears. After plunging to 13x in March, the ratio rose to 19x in October, slightly above the 18x long-term historical average. Therefore, the S&P 500 seems to be fairly valued at current levels. Considering that the corporate profits outlook appears to be rosy for the equity market and that the S&P 500 is fairly valued, it is important to project the index performance in the years ahead to assign the right weight within the portfolio. We will use a model derived from John Bogle (founder of Vanguard mutual fund group) to estimate the S&P500 performance in the next 10 years. The model takes into account the average earnings of the past ten years and the average annual earnings growth of the past 30 years. It subsequently calculates the S&P500 weighted average growth rate so that at period end the index is in line with the average of the past 30 years. The chart below gives clear evidence that the model has historically been able to anticipate the S&P 500 performance for the subsequent 10 years. At current prices, the weighted average earnings growth over the next 10 years stands at 6%, which should then be added to the annual dividend, now at around 2%. Should these projections be confirmed, the equity market performance in the years ahead would be in line with the historical average. Given also the low level of interest rates (the ten-year U.S. Government bond is at 3.53%), we would recommend assigning at least a neutral weight within institutional investors’ portfolios.