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