Saturday, January 7, 2012

Corporate Earnings Outlook

S&P 500 earnings are predicted to rise 7% in the December quarter.  Three months ago the forecast was 15%.  Over the same time the economics community raised its outlook for GDP growth and employment.  Part of the shortfall stems from weaker than expected bank earnings.  The main culprit, though, is declining productivity.  The number of units is going up, bolstered mainly by a pick-up in consumer spending.  But unit costs are increasing, too.  Since early 2009 profit margins had been expanding, driving up profits faster than sales.  That trend has now reversed, at least temporarily.  Analysts predict that S&P 500 earnings will grow 4% in Q1 and another 4% in Q2.  Then they see things accelerating in the second half of the year, which is a customary way of looking at things on Wall Street.

It's a complicated situation with plenty of cross currents.  It's possible the conventional view will prove correct.  The U.S. Dollar has appreciated in value by 10% against the euro over the last two months, though.  That alone could throw today's predictions off the mark.  Foreign profits will be translated at less favorable rates going forward, if the new scenario holds.  Plus U.S. exports will be placed at a competitive disadvantage to European producers.  The tailwind exports are providing to U.S. business could slow in upcoming periods.  Slower growth around the world could amplify the impact.  We'll see how that goes but with every country in the world except the United States driving its currency down to protect its industry, American earnings might take it on the chin a little harder than most people expect.

The situation in China is another wild card.  That country probably will perform well over the long haul.  But most countries in early stages of development experience a variety of booms and busts.  And it looks like China could be in for at least a modest pullback.  The realization might be postponed for a year as the old government exits the scene in October, ideally on a positive note.  But significant adjustments appear to be in the cards.  All that might not have a material effect on U.S. corporate profits.  But it isn't likely to have a favorable one, either.

If earnings stall it's hard to see U.S. stock prices advancing sharply across the board.  They might, if it's just a brief slowdown in growth, not a reversal.  Still, our advice is to focus on high potential growth companies that are capable of producing superior results even if the overall economy flattens out.  P/E multiples are a little on the high side now, fueled by the Federal Reserve's easy money policy.  Worthwhile gains remain possible, nonetheless.  And the companies we focus on here are likely to reinforce their competitive advantages in today's uncertain business climate, laying the foundation for even larger gains ahead.

Walter Ramsley
Executive Editor

Friday, January 6, 2012

Deja Vu All Over Again

Hope springs eternal in the investment world.  A few curmudgeons may make their mark as curiosities.  But optimists rule the day on Wall Street.  And rightfully so, most of the time.  Over the long haul U.S. equity prices have appreciated 8% in value per year on average, including reinvested dividends.  That's outpaced bond portfolios by 3%-4% a year, depending how it's measured.  And even bonds have beaten inflation by a point or two, again depending on the time frame and the particular indexes used.  Looking at things one year at a time, the U.S. stock market has gone up three years for every one year it has gone down.  Wall Street makes its money by selling to securities, and it's easier to sell them when prices are rising.  Plus the odds actually are in favor of an advance, just looking at the long term data.  So it's not surprising the investment community is bullish today.  It's a natural instinct.  Whether there's any logic to it remains to be seen.

Prices are floating higher on the wings of Benjamin Bernanke's latest money printing scheme.  Let's call it "QE-squared" (Quantitative Easing - Europe).  The Federal Reserve shoveled half a trillion Dollars to Europe to support the banking system there.  It also persuaded the European Central Bank to "exchange" $600 billion of bad debt held by European banks for freshly made euros, propping up their balance sheets even further.  All that new cash is driving the euro down in value, which actually is making Germany and France quite happy because it's boosting their export competitiveness.  It's all looking good right now.  Same as it did when the Federal Reserve undertook its QE-2 routine last year.  Everyone thought they'd found an easy way out.  But there wasn't a genuine improvement in economic activity.  Inflation picked up.  Real incomes declined.  And that was that.

Here's our prediction.  The price of gasoline and other commodities will jump, just like they did the last time.  Last time the economy was cushioned by rising labor productivity.  That peaked in Q3 of 2011 and is still declining.  So the inflation impact might be harder this time.  Maybe some of the pressure will be alleviated by a warm winter, reducing heating bills.  But unless the supply of goods and services picks up the leap in the money supply is bound to show up.  That will nip consumer spending in the bud.  Maybe Europe will avoid problems.  Maybe China will keep it together while a new government is formed.  But whatever happens, the world is not going back to normal.  The zero interest rate policy and the massive deficit policy will continue.  That's going to scare people, and keep progress under wraps.

Our advice is to remain cautious.  Right now monetary policy is amazingly expansionary.  The Obama Administration is just creating money like crazy.  The monetary base, which usually grows 5% a year in normal times, is up 30% over the last 12 months.  Free reserves at the Federal Reserve, which usually total $3-$5 billion, are now over $2.2 trillion.  The federal budget deficit, which normally is 2%-3% of GDP and temporarily peaks at 6% for 1-2 years when the need arises to prime the pump, currently is 9%-10%.  And it's been there for three years.  And the Government wants it to go up in 2012.  Maybe it will all just blow over.  Our recommendation is to prepare for an adjustment process, though, one that might involve some material pressure on the financial markets. 

Walter Ramsley
Executive Editor