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Investor Skepticism At Odds With Analysts' Optimism
July 1, 2010
English philosopher Roger Bacon once said, "Half of science is asking the right questions." At present, it appears that investors and analysts are not asking the same questions — or at least that they are arriving at different answers. While analysts have gradually raised their corporate earnings estimates and related price targets, the decline of the S&P 500 Index since April indicates that investors are not so convinced. Given such divergent perspectives, we have assembled a few questions of our own to help determine what we can realistically expect for the rest of 2010.
What is the prospect of prolonged low to negative inflation?
The Street is rapidly waking up to the fact that a V-shaped recovery is not developing. As the economy ekes out modest growth, strong employment gains have failed to materialize. Here in the U.S., small business accounts for roughly 50% of all jobs created, so employment recovery is heavily dependent on small business recovery.
Unfortunately, small businesses tend to be concentrated in industries worst impacted by the credit crisis (think general contractors, construction trades, and real estate services). Where modest improvements have been reported, such as in the real estate market, they were, at the margin, attributed to the Federal Housing Tax Credit incentive program rather than to a genuine, widespread strengthening of the sector. Without meaningful, organic growth small businesses are unlikely to expand employment rolls in the near-term.
The May 2010 National Federation of Independent Business report of Small Business Economic Trends¹ suggests that employment levels are nevertheless improving (ever so slightly), despite the persistence of tight credit and weak consumer demand. According to the report, "What businesses need are customers, giving them a reason to hire and make capital expenditures and borrow to support those activities."
If there is any silver lining to high unemployment, it is low inflation. Macroeconomic theory posits an inverse relationship between unemployment and inflation (known as the Phillips Curve). In general, the lower unemployment is, the higher inflation will be, and vice versa.
This all hinges on a balancing point called the "natural rate of unemployment." Inflation is impacted as unemployment swings higher or lower from this point.
Unfortunately of late, the natural rate of unemployment has been the subject of some academic debate. During the last boom cycle, it was thought to be around 4% — 5%. Many economists now estimate it at around 6% — 8%, suggesting that excess capacity will become a permanent feature of our economy over the next few years as high unemployment persists.
Fed Funds futures tell a similar story of tame inflation well into 2011 (see table below).
| Fed Funds Futures | ||||
| Expected Fed Funds Rate | 0.00% | 0.25% | 0.50% | 0.75% |
| Jun 2010 | 18% | 82% | n/a | n/a |
| Aug 2010 | 17% | 78% | 5% | n/a |
| Sep 2010 | 16% | 73% | 11% | n/a |
| Nov 2010 | 15% | 70% | 15% | 1% |
| Dec 2010 | 13% | 64% | 20% | 2% |
| Jan 2010 | 11% | 54% | 29% | 6% |
Keep in mind, too, that inflation has historically been at very low levels, with the economy experiencing sub-3% inflation for most of the last 140 years. Using Robert Shiller’s S&P data2, which contains monthly Consumer Price Index (CPI) figures to adjust returns for inflation, we measured by months the number of year-over-year inflation periods above and below 3% (see chart right). 60% of the time, inflation was below 3%, with higher inflation dominating only recent time periods (1967 — 1991). If we exclude these years, inflation managed to break 3% only about 30% of the time. Considering this historical data against the backdrop of the global deleveraging process now underway, we expect low inflation to continue in the medium term.
How will low (or possibly negative) inflation affect corporate earnings growth?
To examine this issue, we once again looked to the Shiller/S&P data. When measured on a year-over-year basis, we found that, not surprisingly, earnings tend to respond positively to inflation. More interesting was the fact that it did not take much inflation to produce decent positive earnings growth (chart at right). Even with inflation as low as 1% earnings were sometimes able to grow, on average by roughly 10%!
That being said, of some concern is the fact that corporate earnings tend to contract in deflationary environments (that is, in times when inflation is negative). While the current CPI rate of 2% is a comfortable distance from this territory, it is trending toward the danger zone. The CPI was 2.7% as recently as December — now 2.0%. Core CPI3 at that time was 1.8% — now 0.9%. Indeed, it is this core rate of inflation that makes us most anxious. In December 2007 it was 2.4%. By the following December it was 1.8%. Now, five months into 2010, it has declined to 0.9%.
| Declining Core CPI | |
| December 2007 | 2.4% |
| December 2008 | 1.8% |
| December 2009 | 1.8% |
| May 2010 | 0.9% |
We also examined cross-sectional data over various time periods and found surprisingly poor performance in recent decades where inflation measured 1.5% or less. With the CPI index hovering at 2%, it is not difficult to see why investors have lost confidence in the current macro-environment.
How will the market react to slower earnings growth?
Coming off the recessionary rough in Spring 2009, any growth looked good. The debate then was how strong the recovery would be. Recall that one year ago a slew of initiatives designed to stimulate the economy were in full effect: the $3 billion Car Allowance Rebate System ("Cash for Clunkers"), the $787 billion American Recovery and Reinvestment Act (tax relief and infrastructure spending), the $320 billion FHA Housing Rescue, and the $25 billion Making Homes Affordable program designed to prevent foreclosures. Some of these programs have now expired and others have drawn down the bulk of their funds. Now we must consider what the year-over-year numbers will look like absent many of these government stimulus programs.
According to S&P 500 Index earnings estimates compiled by Bloomberg, consensus bottom-up analyst earnings estimates have generally been increasing since January (blue line at right). On the other hand, investors in the S&P 500 are not so bullish (red line at right). With the Index off nearly 12% from its late April 2010 high, investors are obviously discounting analysts’ estimates as overly optimistic.
In truth, analysts are slightly guilty of staring too intently into the rear view mirror, consequently missing a turn here and there. Conversely, investors who eschew the benefit of historical perspective tend to proceed white-knuckled through the economic landscape, their vision impaired by the fog of fear. Both camps are prone to hyperbole. We suspect that Q2 earnings announcements will impose a much-needed dose of reality on both sides, with volatility as the principal side effect.
In fact, the upcoming earnings season is shaping up to be quite interesting, especially in light of newly planned restraint programs across OECD4 countries. Will EPS estimates be revised down? Or, if they are accurate, is there enough future growth behind them to warrant a PE multiple higher than the current 13x? Regardless, the market may be truly forward-looking in that it may already be discounting bearish 2011 earnings estimates.
We suspect there is some room for growth, but this is a "show me" economy in which companies need to prove their guidance with bona fide earnings before the market will reward them. If companies begin revising down their guidance in the next few weeks, it might be time to fasten your seatbelts.
Copyright 2010 Saturna Capital Corporation and/or its affiliates. All rights reserved. Vol. 4 · No. 7
¹ NFIB Small Business Economic Trends. May 2010. http://www.nfib.com/Portals/0/PDF/sbet/sbet201006.pdf
² S&P 500 data is gathered from Robert Shiller’s “Stock Market Data,” which is available at http://www.econ.yale.edu/~shiller/data.htm
³ Core CPI, generally used to measure inflation, is CPI excluding energy and food prices.
4 Organisation for Economic Co-operation and Development
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