Measuring the Year Ahead

Jan 09 2012

Measuring the Year Ahead

Posted by Carol Bakes in Easy Finance

Given the abundance of unresolved issues left over from last year, perhaps it is no wonder that the range of forecasts for 2012 seems unusually polarized. Expectations seem to be clustered at either end of the spectrum, with little middle ground. Stocks are expected to produce either strong returns or sharp losses. The question of corporate earnings growth and its meaning illustrates the point.
One of the places many investors begin in their determination of whether or not stocks are attractive is the market’s price-to-earnings, or P/E, ratio. But admittedly, this metric is problematic, since for every one of its positive aspects there seems to be a corresponding negative. For example, assuming fourth quarter earnings projections for the S&P 500 are accurate, the market ended 2011 with a trailing P/E ratio of 12.9 based on its closing price of 1258. This represents a significant discount to the market’s thirty-five year average trailing P/E ratio of 16.8, according to Bloomberg. Over this time the P/E has been as high as 30.2 in 1999, a market top, and as low 7.0 in 1980, a market low. Some might argue that the past year’s volatility prevented the market from fully recognizing the earnings growth that has already been delivered and therefore a more benign environment would allow for an upward price adjustment. However, this discount could also be just as easily dismissed if it turned out that earnings were close to their cyclical high, and were destined to fall, as some others believe.
Citigroup points out that as a percent of GDP, earnings have never been higher in the past thirty-five years and that profit margins, also at historic highs, will contract in the year ahead. Still others point out global macro headwinds will make it difficult, if not impossible, to achieve the earnings growth currently expected by the consensus of $108 for the S&P 500. On that basis, the S&P ended the year with a forward P/E ratio of 11.6, or a 15 percent discount to its thirty-five year median of 13.6. This forward measure has also experienced a similar range of highs and lows as the trailing measure over the thirty-five year time frame. But the problem with estimated earnings is that they are just that, estimates. And estimates are subject to revision. Given a possible recession in Europe, an uncertain slowdown in China, an election year in the U.S. etc., it is easy to see how fragile any forecast might be, even on top of the fact that 2012 earnings growth has already been discounted to a consensus 10 percent rate from 17 percent one year ago.
Another problem with the standard P/E ratio is the fact that any one year is simply a snapshot in time. It might be significantly better or worse than a longer-term experience. For that reason, Robert Shiller argues for using a ten year average of earnings as a better gauge of sustainable corporate earnings power. On this basis, stocks ended 2011 at a P/E ratio of 21.4, slightly higher than the thirty-five year median of 20.0, but hardly expensive. In 2009, this ratio was 15.8 and provided a strong buy signal. But in 2002 it was 30.1 and might have kept you from participating in the 80 percent total return delivered by the S&P 500 over the next five years.
So are stocks cheap or not? It seems that the worst you might conclude is that stocks are currently fairly valued. An argument can also be made that stocks are somewhat undervalued. But it is a more difficult argument to make that stocks are expensive. Of course, a lot depends on your expectations for economic growth prospects in 2012. Those who expect little from stocks in the year ahead generally expect growth no better than 2.0 percent in the U.S., held back by weakness overseas. The more bullish believe growth of 2.5 to 3.0 percent is achievable. The Blue Chip consensus forecast calls for growth of 2.2 percent, while the Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters calls for 2.4 percent.
My own expectation tends toward the more optimistic. Four years of consumer deleveraging and massive monetary stimulus are beginning to have a salutary effect. As the presidential election comes into focus, the rules of the game will become clearer, allowing for investment decisions to be made at both the corporate and individual level. At current prices, stocks are attractive, especially for those with an intermediate to long-term investment horizon.
Important Disclosures: The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Ameriprise Financial associates or affiliates. Actual investments or investment decisions made by Ameriprise Financial and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon, and risk tolerance. The S&P 500 is an index containing the stocks of 500 large-cap corporations, most of which are American. The index is the most notable of the many indices owned and maintained by Standard & Poor’s, a division of McGraw-Hill. It is not possible to invest directly in an index.
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