US earnings expectations, still far too high!

Since the spring of year 2000, the consensus forecast for the S&P 500 operating earnings per share for the year 2001 has been steadily coming down from a peak of around $68 in the first quarter of 2000 to just $52 at present. But for the year 2002 the consensus among US financial analysts is still expecting S&P 500 earnings of almost $63, which would mean an increase in earnings of close to 20% for next year.

How likely is such an outcome? After all this would mean that year 2002 earnings would exceed the record of $56 reached last year, which was up from $21 in 1991.

It is important to understand that over the eight years ending in 2000, US nominal GDP growth averaged 5.7%, but earnings growth was around 16% per annum. This was due to some unusually favorable circumstances, such as declining interest rates and commodity prices, frontloading of revenues and earnings during the investment boom, option compensations, share buybacks, and outsourcing.

A repeat performance of this extremely favorable environment for corporate profits is, however, unlikely in the foreseeable future, because of higher depreciation charges and higher levels of corporate debt. Therefore, it would be most unusual for 2002 corporate profits to exceed the record level achieved in 2000.

In fact, the most likely outcome is that for the next few years, S&P operating earnings will at best be in a range of anywhere between $40 and $50, which would give the S&P 500, at the current level of around 1,200, a rather demanding valuation.

But, if you think that I am pessimistic, consider a recent analysis by Bridgewater Associates. This looks at three different GDP scenarios over the next three years, whereby in the 'weak scenario,' GDP grows by 1% in 2001, -1% in 2002 and 2% in 2003. In the 'normal scenario,' GDP grows by about 3% annually in the next three years, and in the 'strong scenario,' it expands by about 4% annually.

According to Bridgewater Associates, a number of factors that drive corporate earnings are either baked in the cake, or reasonably estimable, such as the cost of the previously issued long-term debt and the cost of depreciating previous capital expenditures.

The hardest part is to project GDP growth. But, given reasonable estimates of these and other components overlaid on to different scenarios for GDP growth, it is possible to obtain quite accurate estimates of future earnings under those GDP growth scenarios.

Thus, according to Bridgewater Associates, under the most optimistic scenario for real-GDP growth, real profits fall by 10.9% per year over the next three years. Under the normal growth scenario profits will fall by 14.5% per year and under the weak growth scenario by 23.2% per year.

Bridgewater Associates conclude that while analysts still believe that future earnings growth will be around 16% per annum in the foreseeable future, such as we had in past eight years, this is unlikely. The reason for this pessimism is the increase in operating leverage caused by the debt-financed investment boom, and the non-sustainability of benign labor cost increases and strong productivity gains.

Similarly the author Peter Bernstein, admonishes the analysts' five-year forward consensus expected earnings growth of 16% per annum. He argues that since 1936, nominal GDP growth averaged 7.9% per year, while S&P earnings per share have grown at annually 6.7%. According to Bernstein, the longest run of years with EPS growth of more than 10% a year was from 1992 to 1996 (four years) and the next longest runs over 10% came to only three years - and there were only two of these.

He, therefore, finds that, double-digit earnings projections 'over the long run' appear senseless at face value, without even taking into consideration the elevated base of year 2000 from which future earnings will be jumping off. His conclusion is that, the case appears equally foolish when we adjust for the distortion inflation has imposed on the nominal figures.

Real earnings growth over spans from five years upward averages 2% a year at most; from 1959 to 1995, the figure works out to 1.8% a year, just about the same as from 1929 to 2000. To go from two percent or so real growth at best, to double digit growth implies a rate of inflation so powerful it would drive earnings multiples way down into single digits.

Thus, it would seem to me that US financial analysts and investors are still far too optimistic about future earnings growth and likely to be repeatedly disappointed. As a result we maintain our cautious or rather negative view about US financial assets.