The Q1 earnings reporting season is upon us and expectations, based on the stock market’s recent behavior, are lofty.
While gallivanting through South America, let’s turn to David Rosenberg, chief economist and strategist of Gluskin Sheff & Associates, for a few comments on valuation levels.
“The earnings outlook is bright and even our regressions suggest that we will get 15% EPS growth in 2010 (the consensus is at 36%), which is completely normal for the type of nominal GDP growth we are going to see.
“Keep in mind that we are not going to get the intense expense cutting we have seen in the past year, which has seen unit labor costs decline at a record 4.7% rate, or are we going to see an unprecedented string of productivity gains, which have averaged at a 7.4% annual rate over the past three quarters. So, that would bring us closer to $68 on earnings than the $78 consensus view – a view that Sam Stovall from S&P uses to come up with a Goldilocks 15x forward multiple to then apply to a median (since 1988 no less!) of 19x to come up with the view that this market is still dirt cheap. Well, if you are willing to assume that there was a stock market before 1988 and use a real historical average (back to 1980, for example), then the average is closer to 14x. And if our EPS projection is closer to the mark, then the market is trading at a 17.3x forward multiple or is 20% more expensive than what would ordinarily be considered normal.
“As for 2011, the consensus is looking for $97 on S&P 500 operating EPS — we did $95 at the peak of the last cycle when the unemployment rate was at 4.5%, the industry CAPU rate was 81%, private sector credit expanding at a 16.2% annual rate and nominal GDP at a 4.9% YoY pace. So the consensus believes that barely two years into the second weakest post-recession recovery in the past six decades we will actually get back to peak profit levels seems to be a tad outlandish.”
The chart below, courtesy of The Big Picture, saves you to do the maths and provides a useful table for reading off S&P 500 levels implied by different price/earnings (PE) ratio and operating earnings combinations.
Source: Standard and Poor’s, Compustat, FactSet, J.P. Morgan Asset Management.
