According to Yardeni Research, the 3rd quarter of 2010 saw corporate America reach near record profit margins of 8.6%. One obvious way of growing corporate profits is to grow profit margins, but to plan on outsized margin growth from today’s record levels seems a little too optimistic. In fact, profit margins are mean reverting so while margins could still expand from here it seems more likely that investors should plan on flat to lower margins in the future. Another way to grow profits is to increase corporate top line sales growth. U.S. consumers continue to confound bearish analysts (I include myself in this group) who thought that consumption might be curtailed by stubbornly high unemployment statistics. The dismal number, including part-time workers who want to work full-time as well as discouraged workers who have recently dropped out of searching for a job, remains at about 17% of the workforce. You might also think that consumers would be less than enthusiastic if their home values continued to fall, which according to Case-Shiller- they have for the past four months. Nonetheless, year over year growth of retail sales was 7% by the end of November and real personal consumer expenditures grew by 2.5%. Not bad for an economy that is supposed to be saddled with consumers who are anxious to cut their spending and repair their balance sheets.
Historically investors would, quite sensibly, discount the amount that they are willing to pay for future earnings when profit margins are at record highs. In that light, paying 13 times next year’s projected operating earnings makes sense. To be exact, at today’s S&P 500 price of 1276 and current consensus 2011 operating earnings estimates of $95, the market is trading at 13.4 times estimated 2011 earnings. The question is, is 13 times earnings too low in the midst of an economic expansion? Over the past thirty years the median forward operating earnings multiple is 14 times earnings. Of course, for most of the past 30 years interest rates haven’t been at 0 and the Federal Reserve didn’t more than double the size of its balance sheet. Is it possible that investors should give this economic recovery a little more benefit of the doubt?
To get to this year’s (2010) estimated per share earnings of $83.75 companies grew operating earnings at an amazing 38% year over year rate from 2009. To get to the 2011 forecast of $95 we need a more reasonable 13% growth rate for operating earnings. If investors simply give the market its median multiple of 14 times 2011 earnings we could see the S&P 500 trade to a price of 1330 without any growth in earnings estimates for 2011. A multiple of 15x, which in my mind is unwarranted, gets us to 1,425. For the market to advance without an expansion in the multiple, something good needs to happen with consumer spending or corporate profitability. I’ve seen bullish forecasts of 4% GDP growth for 2011 fueled by 4% increases in consumer spending. Against the backdrop of an economic expansion, perhaps consumers will come to the rescue and the bulls will be rewarded. It seems as though everyone is making an argument to be more bullish nowadays.
