Shaping a portfolio for 2012 (V): the S&P 500 this year

4Q11 earnings season begins today

4Q11 earnings report season begins with AA after the close this afternoon.  According to theFinancial Times, Wall Street analysts are predicting that the companies in the S&P 500 will report another in a long line of quarters of year on year profit expansion, but at a rate under +10% for the first time since 2009.

There are four reasons for the weakening of the earnings comparisons:

–the € has weakened recently as the financial crisis in the Eurozone deepens.  That means a fall in the dollar value of profits earned by S&P 500 members in the EU.

–in response to Euro worries, wholesalers and retailers globally decided to reduce the amount of inventory they have on hand.  So they cancelled orders for merchandise that they would normally have bought from producers in 4Q.

–widespread flooding in Thailand led to hard disk drive and auto component shortages, meaning some products couldn’t be built and shipped

–economic growth in the emerging world continued to decelerate.

The component shortages and inventory shrinkage are temporary.  € weakness may be as well, depending on how the Eurozone crisis plays out.  If so, their main impact will be to transfer, say, 1% of yearly corporate earnings growth from 4Q11 into 2012.  As far as 4Q11 is concerned, however, the four together have probably been enough to offset all the positive effect on S&P earnings of a strengthening US economy.

According to the FT, S&P 500 earnings per share for full year 2011 will amount to $96.38, surpassing the previous for the index of $87, in 2007.  Given the sharp decline in reported earnings from financial companies since then, the 2011 figures document a huge rebound in performance by non-financials.

What about 2012?

The FT says the current consensus calls for eps of $106+ for the S&P this year, a gain of almost 11%.

My take is that that figure is really optimistic.  I also think that the analysts whose earnings estimates underlie this figure are assuming no negative impact on results from the financial crisis in Europe.  While that’s possible, I don’t should be one’s base case.

My assumptions are as follows:

base case

US (50% of S&P 500 earnings)       10% growth          = mild acceleration

Europe (25% of S&P 500 earnings)      5% decline          = significant deceleration

Emerging markets (25% of S&P 500 earnings)  15% growth          =significant deceleration

total          7.5% eps growth

optimistic case

US          +10%

Europe          +5%

Emerging markets          +15%

total          +10%

pessimistic case

US          +10%

Europe          -15%

Emerging markets          +10%

total          +4%.

Two observations:

–if I’m correct that some of the factors depressing 4Q11 eps are temporary, their reversal in 2012 should add a bit to 2012 S&P eps.

–in order for the pessimistic case to produce negative year on year eps for the S&P, European profits would have to fall by 30%.   While this is also possible, I don’t think it’s likely.

what about the multiple?

My pessimistic case yields eps for the S&P 500 of around 100.  The optimistic case generates eps of about $107 (i.e., the consensus).

If we apply the current market multiple of 13.5x to these numbers, we get an expected index level by mid-year of 1350 on my pessimistic view, 1450 or so if we’re optimistic.

In other words, it’s reasonable to expect single digit gains for the S&P from today’s level based on 2012 earnings.  Add the current 2% dividend yield on the market to this and expected total return from owning US stocks appears more worthwhile, if not up to the standards of 2009-2010.  It’s certainly better than bonds.

What could move results outside this range of possible outcomes?

–good/bad sector and stock selection

–rise/fall in the multiple applied to the earnings (decreased uncertainty could move the multiple in a positive direction)

–severe economic problems in China (unlikely, in my view) or implosion in the Eurozone (a year ago, I would have said this was impossible.  I still rate an extremely unfavorable outcome as unlikely, but it’s no longer inconceivable).

That’s it for today.

Tomorrow:  putting the pieces of I though V together.

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