That being said, I remember when my wife and I, and many of our friends, were getting ready to have kids, she did this ring test. There are a couple of versions of this test, which involve dangling a ring from a chain or thread over a woman’s palm or pregnant belly.
It proved remarkably accurate in presaging both the sexes and number of children we would have. It also worked accurately on all the friends she tried it on. I don’t know why it seems to work, but in my experience it has been far more accurate than any guesses analysts have ever made on corporate earnings.
Yet this crystal ball gazing is exactly what the bulls are touting. You have heard it all over the mainstream financial media: “Stocks are cheap! They are trading at a mere 13 times forward earnings estimates!”
Hogwash is my answer, and that is based on the single number that will drive the markets this coming earnings season and into the second half of 2012.
The Reversion Can be Mean
Stocks, bonds, commodities, etc. rise and fall, but most return to some kind of average. That return to the average is described as “mean reversion”. There are a number of useful trading strategies that focus on mean reversion. But I am not writing today about a specific stock, rather the outlook for the coming earnings season.
Like stocks, profits also return to average levels as a percentage of total economic output over time. Corporate profits are currently at record highs. Given the European situation and a domestic economy that is bumping along (an anemic 1.9% according to yesterday’s final reading on Q1 GDP), there is little reason to believe that these record profit margins will continue.
Stock prices are driven by profits, and the important thing to understand is that all the earnings estimates derived from the analysts’ crystal balls are making the assumption that they will remain at record levels. In fact, they are expecting margins to expand further, and that could lead to some substantial disappointments in the coming weeks and into the coming quarters.
How Low Can You Go?
These gurus of the glass globe were estimating around $103 in earnings for the S&P 500 in 2012. That would suggest a P/E (price to earnings) ratio for the index of about 13. They have begun revising lower of late. Now, 13 times earnings is not terribly cheap, but it is not bad.
But what if they are a bit overly optimistic?
That 13 times earnings would require a 10.2% profit margin for the S&P 500, but if earnings fall to the 5 year average where profit margins are about 8.4%, then you’re talking about only $85 in earnings. That translates to a 16 multiple on the index. Not quite as cheap.
Further, should margins shrink to the long term average of 6.1% of GDP, now you are talking about a mere $62 in earnings on the S&P and a multiple of 21! That is not cheap!
The earnings reality is likely to be somewhere in between the peak and the long term average (I don’t have a crystal ball), but you have to ask yourself:
- Do you believe analysts' estimates?
- Do you believe profit margins can continue to hit records while the global economy is hanging onto positive growth by a thread?
Profit margins will be key during this earnings season, and they are likely to begin contracting soon. In fact, numbers on profits released yesterday from the Bureau of Economic Analysis showed that Q1 corporate profits, adjusted for inventory and capital consumption, fell 4% as a percentage of GDP from the prior quarter. That shows up as the downturn in the black line in the above chart. It has already begun.
Be nimble this earnings season, and keep an eye on those critical margins.
Price Shock Trader