Following his insightful and profitable predictions on the mess in the U.S. mortgage market, bond manager Bill Gross is trying to sour investors on the stock market. The founder of the giant bond firm Pimco expects stocks to return no more than five percent for the intermediate term, as Americans swear off their foolish spendthrift ways, and decimate corporate profits in the process. There’s no question that Bill Gross is one of the great investors of the era, but is his pessimism warranted by the prospects for U.S. profits?
As usual the long-term record is enlightening: the graph below traces the paths of the price level and earnings per share of the S&P 500, from 1970 to the present, as chronicled by Professor Robert Shiller of Yale. (Click on the graph to see a larger version.)
Dr. Shiller reports that earnings for the S&P 500 fell to $7 in mid 2009, down from their $84 peak a few quarters earlier. More happily, the forward-looking analysts tracked by the uncanny StarMine ranking system are looking for S&P 500 earnings to recover to $71 per share by second quarter 2010. The soaring part of the graph’s earnings line, with the green dots, represents an extrapolation from the sad reality of 2Q 2009 to their consensus one year out.
Further ahead, equity managers in a Bloomberg survey see profits climbing an average of 26 percent for calendar 2010, and a further 22 percent in 2011, reaching $91 per share. So which camp stands the better chance of being right on this call? Is the profit recovery over already?
If past cycles are a reliable indicator, S&P 500 earnings should have no trouble bouncing back to $70 per share. But the essential questions in this dispute are: How much future growth has the market already discounted? and How likely is the S&P to produce the back-to-back growth needed to reach $90 in earnings per share?
As for the easier question, the S&P 500 is already up 58 percent from its March low of 666. Using StarMine’s analyst consensus, the valuation on forward earnings is a price-earnings ratio of about 15 times. That’s above the 13.5 monthly average prevailing from 1970 to 1994, but just a fraction of the 29 p-e ratio average from 1995 through the present day. (Ex the tech bubble, from 2003 to the present, the average p-e ratio was about 24 times.)
Expecting the market to recover to the last ten years’ valuations is probably naïve, but one point in the equity bulls’ favor is that according to StarMine’s panel of analysts, the S&P 500 is “selling at below its growth rate.” That is, the valuation on expected 2010 earnings of 13.5, measured in p-e ratio points, is below the 17 percent expected growth, measured in percentage points. By tried-and-true guidelines, that difference suggests that the market could rise 20 or 30 percent before reaching full valuation.
Gross told Bloomberg he sees earnings growth flattening out soon due to Americans’ move to a thriftier lifestyle:
“Returns mimic nominal” gross domestic product, Gross, manager of the world’s biggest bond fund, said in an interview [September 29] with Bloomberg Radio. “Nominal GDP is the growth rate of wealth on an annual basis. The new normal is 2 to 3 percent GDP and real growth of 1 to 2 percent.”
Echoing Gross is former Fed chairman Alan Greenspan, an advisor to PIMCO:
“The odds are we flatten out,” Greenspan said today in a Bloomberg television interview, referring to the equity market. “That flattening out will put some sort of dull face on 2010.”
A dull face indeed. That’s the sort of down-at-the-heels America that Peggy Noonan colorfully foretold a few months ago.
The record shows Gross is probably too gloomy: In predicting just five percent returns for equities, he overlooks the past resilience of the U.S. economy, and the historical record that corporate profits have far outpaced GDP when coming out of recessions, even as consumers scaled back. After the difficult slowdown of 1981, S&P 500 profits grew a total of 15 percent in the following three years.
But in the three years following other recessions, cumulative S&P 500 profit growth has reached 59 percent (after the 1973 slowdown), 92 percent (after 1991) and 137 percent (after 2001).
Even with a few points deducted for a thriftier America, and a market that’s already up over 50 percent, there should be enough room for 10 or 15 percent growth in share prices over the next few years.
Financial disclosure: The writer owns a lifetime supply of stocks.
