Sent: 04-08-2009 11:26:01
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The U.S. Market Recovery
The recovery in U.S. equity markets is based on a cyclical trough in earnings last December and a continuing stronger than expected earnings recovery.
In my 17 March commentary on U.S. market conditions, I questioned whether the potential earnings recovery was going to be strong enough to validate the U.S. equity market levels at that time. Since then, the S&P 500 has risen a further 30%.
S&P 500 operating earnings contracted in the December quarter somewhat less than had been expected but to the lowest levels for any time in the past 20 years. Earnings rebounded in the March quarter. However, having done so, they were still 60% below the previous earnings peak in the June quarter of 2007. They have apparently jumped another 41% in the June quarter, based on over 50% of the earnings reports that have been lodged so far.
This is a better outcome than the macroeconomic conditions implied three or four months ago. Two things have happened to influence markets since then. Macroeconomic conditions appear to have stabilized more quickly and at higher levels than had once been thought likely. At the same time, some companies have been able to achieve cost savings, which had not been fully anticipated, to compensate partially for weak revenues.
Standard and Poor's company analysts are currently estimating that S&P 500 earnings will rise by 11.9% in 2009 and by a further 33.5% in 2010.
But the downside risks remain evident. S&P's top down earnings estimates from its economics department for the year ahead are running as much as 40% below the bottom-up earnings numbers. The top-down estimates suggest an earnings decline of 10% in 2009.
Analysts have trimmed back their company earnings estimates over the past several months but they are still well ahead of what the macroeconomic environment suggests is feasible.
The March ATC article suggested that the market value at the time was consistent with an earnings increase of up to 10% and a p/e ratio of 14. To that degree, the market was accurately forecasting conditions.
With earnings in the recovery phase and short term rates of growth running at an above average pace, investors might be prepared to pay a higher multiple of earnings than later in the cycle when growth settles down to a slower pace. A 12% earnings upturn for 2009 as a whole and a p/e ratio of 18 suggests an index in the vicinity of 1013, within 3% of the current market.
Looking ahead to 2010 - and possibly 30%+ earnings growth - the current market again implies a p/e of 14 times 2010 earnings.
This is not especially expensive or cheap and seems a reasonable starting point from which recovery can proceed, with further market gains tied to continuing improvement in earnings.
However, if the more subdued top down estimates eventuate, a market value of 14 times earnings in 2010 would suggest a level of 640 or 35% lower than the current market price.
Ultimately, companies will be tied to the economies in which they operate. They will be able to achieve cost savings in the short term to prop up profits but, eventually, will have to find a way of getting earnings growth from higher revenues. To the extent that U.S. companies are exporting or generating foreign source income, they might surprise the macroeconomists on the upside. However, the likelihood of surprising the company analysts on the upside appears more limited.
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