Buy The Bottom (Not Yet)

In recent months the majority of S&P 500 companies have reported better than expected second quarter earnings.  This has led to many talking heads on the financial networks to say stocks are now cheap on a P/E (price to earnings) perspective following the recent sell-off.  Earnings per share (EPS) estimates for 2012 are all over $100, putting the S&P 500 P/E ratio below the historical average of 15, hence the “stocks are cheap” argument.

However, what is troublesome with this outlook is it assumes the “E” in the P/E ratio will continue to grow over the next year.  As more and more economic indicators show a weakening U.S. economy, what will happen to the earnings power of companies?  Just like anything else related to the economy, corporate profits tend to run in cycles as the economy grows and contracts.

Several studies have shown a correlation between the GDP growth rate and EPS growth.  In fact, accordingly to Goldman Sachs’ EPS estimates, for every 50 basis point change in GDP growth there is a $2 EPS change in the S&P. 

Goldman’s 2012 earnings estimate for the S&P 500 is $102, however this is assuming GDP growth continues its current rate, which is roughly 1.3 percent as of Q2.  If GDP stays flat in 2012 on a year-over-year basis, that forecast would equate to $94 in earnings.  If you are estimating a contraction in GDP in 2012 (as many now are) of let’s say 2 percent, then earnings estimates drop to $84.

Do you see what is happening here?  The “E” in the ratio is getting smaller, which in turn pushes the P/E ratio higher making the mirage of cheap stocks quickly disappear.  For a great "cheap stock" buying opportunity what we need to see is a P/E ratio well under 15 based on real current earnings, not forecasts. 

If GDP is likely to weaken over the coming quarters, which is our point of view from previous letters. (Please recall from earlier letters the topic of less than 2 percent year-over-year GDP growth and the recessions that follow) The smarter bet is that S&P earnings begin contracting in 2012 as opposed to growing further compared to 2011.

The key is recognizing which sectors hold up best during the downturn to trough period of an earnings cycle.  Below is a chart that shows the peak to trough change in S&P earnings by sector.

As you can see consumer cyclicals hold up best, which has always made sense since people need to eat, babies need diapers and so on and so forth.  However, since these are necessities growth is also limited as not much excess is going to be purchased.  Hence, the smallest profit growth among the sectors during expansionary or “good” times.

Finally, with this said I would look to by heavier in the “defensive” names (consumer cyclicals) over the next year as earnings begin to come down sometime in 2012 since the pullback is not as volatile in that sector.  Then when the P/E on the S&P 500 gets down toward the 10 mark calculated on real earnings, look to get aggressive with other sectors such as financials and tech.

Sidebar:  I've mentioned gold as a safehaven investment several times, especially when the debt debates were occurring in Washington, however, the recent run is finally looking parabolic after a nice steady rise over recent years.  Gold could very well hit $2500 an ounce at some point, but I would be a lot more cautious going forward and only look to add on sharp pullbacks as the chart is starting to look like a dot com stock in 1999.  However, so long as the U.S. continues running up debt and the Fed has a anti-dollar fiscal policy I will remain bullish on gold.

Your getting ready to ride out the earnings downturn analyst,
Mitch Jaworski

Return of the Credit Binge

Alot has happened in the last two weeks, most of which continues down the wrong path for the U.S. economy and leads us to delve further into familiar topics from the last two letters.

A first estimate of GDP for Q2 was rather disheartening, coming in at 1.3 percent. This was below estimates and down from Q1.  If you recall, we pointed out anytime GDP has fallen below 2 percent year over year growth that an economic recession follows.  Below is the referenced chart, periods shaded in orange represent periods of recession.

The economy was creeping close to this figure in Q1, posting a year-over year growth rate of 2.4 percent.  The initially reading for Q2 GDP places the economy at 1.6 percent year-over year growth, below the key 2 percent threshold.  So unless we see an aggressive upward revision to the second and third estimates of GDP (which is unlikely), I believe the outlook for a double-dip recession pretty much speaks for itself.

We some lower level evidence of a weakening economic picture when analyzing consumer credit.  As mentioned a few weeks back, credit card use jumped in May, a trend that continued in June.  The Federal Reserve reported Friday that consumers increased borrowing by $15.5 billion in June.  

Furthermore, credit card debt surged $5.2 billion for the month, the largest monthly rise since March 2008.  This is not an indication consumers are more willing to finance discretionary purchases because they feel secure in their income producing ability; unemployment is still in excess of 9 percent and only 114,000 new jobs were created in July.

Rather, Americans are using their credit cards more and more to finance daily living expenses as a bridge to their next paycheck.  As mention in earlier letters, this is not a conducive scenario for strengthening consumer spending, a key driver for the serviced based economy, that is our nation, to recover.

Lastly, I cannot conclude this letter without mentioning Standard & Poor’s downgrade of the U.S. credit rating to AA+ from AAA.  Am I surprised?  No, not based on fundamentals I am not.  What I worry about is what it means for the credit of sovereign nations and the possible domino effect that could be coming in downgrades.

If the U.S. was a candidate for a ratings downgrade, where does this leave a country like France for example, who currently holds a AAA rating.  The fiscal health of France is no better than that of the U.S., so is there any reason not to expect a downgrade in their near future?

The coming week will be very interesting for not only the equity market reaction and action in gold price, but for the ripple effect that may be seen in credit ratings. 

Your swimming through the debt current analyst,

Mitch Jaworski