Shaping a portfolio for 2013 (v): S&P 500 performance this year

 S&P 500 earnings

According to the research firm Factset, the Wall Street consensus is that earnings per share for the S&P 500 index will amount to around $103 for 2012.

For this year, brokerage house equity strategists (a “top down” view) are projecting eps for the S&P of about $109.  Aggregating the company earnings projections of brokerage house industry specialists (a “bottom up” view) into an overall S&P forecast yields an eps figure for the index of $113.

If Wall Street is correct about the 4Q12 earnings now in the process of being reported, the S&P has achieved about a 7% year on year eps gain in 2012.  (For what it’s worth, the base case for 2012 profits I came up with in my Shaping… posts a year ago was 7.5% growth.)

Strategists are expecting a slight deceleration in eps gains for this year, penciling in a 6% growth rate. Industry analysts are more bullish (as they usually are).  Their collective wisdom is that the S&P will post close to a 10% advance.

my take

In looking at the S&P, it’s important to realize than only half the index profits are sourced in the US.  The other half comes, in roughly equal parts, from Europe and emerging markets.

the US:  As I wrote a couple of days ago, real GDP growth in the US is probably going to be only about 2% this year.  This implies nominal GDP growth of around 4%.  Profit growth for publicly listed companies, which tend to be the best and the brightest, should be significantly higher. On the other hand, autos and construction, two large industries which I think will be among the better growers, have little direct stock market representation.  Let’s say 5% eps growth.

the EU:  Zero is probably the right figure for profit growth.  If the EU continues to make progress in trying to shape a closer fiscal union, however, the € could continue to rise in value vs. the $.  That would create currency gains for US firms with EU exposure.

emerging markets:  Recent macroeconomic reports, as well as anecdotal evidence, suggest that emerging markets–especially those in the Pacific Basin–are beginning to reaccelerate.  I think a 20% earnings gain is very easily achievable.

Adding this all up:

US:  5% profit growth, a 50% weighting  = contributes 2.5% to overall S&P eps growth

Europe:  no growth, 25% weighting   = contributes nothing

Rest of the World:  20% profit growth, 25% weighting   =   contributes 5.0% to overall S&P eps growth

Total:  7.5% eps growth.

On the surface, this result–the same number as last year–may seem weird.  There’s no way that the US is going to have as good a year for GDP in 2013 as it had in 2012.  However, the point to note is that +7.5% doesn’t have very much to do with domestic profits.  It has much more to do with an end to contractionary government economic policies in China et al, resulting in greatly improving profits from the international divisions of US-listed multinationals.

the market multiple?

During 2012, the S&P gained 13.4%, ex dividends, on a 7% increase in eps.  The remaining gain of 6% or so is due to price earnings multiple expansion.  In other words, despite all the “death of equities” hysteria in the financial media, investors are willing to pay a higher price today for a dollar of S&P earnings than they were a year ago.

Are we at the end of possible multiple expansion?

No one knows.  We can say, however, that on a relative basis, the S&P is still trading much more cheaply than bonds.  The traditional comparison is to look at the interest coupon on government bonds vs. the earnings yield (1 ÷ PE) of the market.  The two should be roughly equal.

As I’m writing this, the 30-year Treasury is yielding 3%.  The S&P has an earnings yield of 7.1%, based on 2012 eps, and 7.7%, based on 2013.  The two yield figures are miles apart, a situation last seen in the US in the 1930s. If we use the 10-year, now yielding 1.9%, as our proxy for the bond market, the disparity is even greater.  It’s possible that any future adjustment will occur solely through bonds becoming cheaper, with stocks never becoming more expensive.  But that’s not usually the way things work in the securities world.

There’s a second argument to be made for multiple expansion.  It’s that the relatively modest S&P multiple is directly related to the parlous state of economic policy coming out of the White House and Congress.  That is to say, today’s stock prices already discount to some degree the future loss of national economic growth and wealth that’s now being cemented into place by the failure of both political parties to address pressing economic concerns of our international competitiveness, continuing high unemployment and continuing deficits.  Were Washington to begin to address these serious structural problems, I think the stock market response would be prompt and positive.  We can always dream.

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