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S&P Forecasts Blue Skies
Sales and Earnings Growth of “7-11” Respectively!

Will the next big move in the stock market be a rise or a fall? Technicians focused on the long term tend to suggest that the next big move will be down, while rationalizing that the rally off of the October 2002 bottom was a cyclical move within a secular bear market. It is relevant to examine long term valuation parameters as well as sales and earnings projections to see where we now are with respect to stock market valuations. An objective examination of these historic relationships suggests that the next big move will be a downward one.

The chart below depicts on a semi-log scale, the long term relationship between price and earnings of the S&P 500 from 1880 to the present. The data to compose this chart was from work done by Professor Robert J. Shiller, author of the book, Irrational Exuberance, and used with permission. Note that except for 1929 and the millennium boom, price to earnings ratios ranged within the green box depicted in the chart. At present, the price to earnings ratio of the S&P 500 is at the top end of the range defined by the green box. Unless this time is different, the odds would favor the price to earnings ratio moving back toward the center of the green box.

Also of interest from the chart above, there is a relatively consistent relationship between major interest rate tops and stock market bottoms. Rising interest rates tend to hurt stock prices (eventually). Low interest rates tend to support higher P/E ratios, yet today’s high market valuations would not appear to be supported by low interest rates.

There are only two ways the price to earnings ratio can be normalized – either stock prices must drop, or earnings must rise. While in the short run they don’t track each other exactly, the long-term relationship between stock price and corporate earnings appears to be reasonably consistent as can be seen in the chart below. So which will it be? Will stock prices fall, or will earnings rise to justify the current relatively high p/e’s? Or will there be some combination of both price and earnings adjustments which will bring the S&P P/E back toward the middle of its normal range?

As you can see from the red line in the chart above, S&P 500 earnings are now at an all time high. Yet over the long run, relatively short periods of little growth or even earnings shrinkage have occurred many times in the past within the rising long-term path of earnings. Will earnings growth remain robust in the near term? Yes, according to Standard and Poors’ aggressive projections. Below is a table that summarizes Standard and Poors’ breakdown of 2006 estimated quarterly operating earnings of the S&P 500 and year over year (YOY) operating earnings percentage growth by sector. They are projecting an 11.6% average year over year growth in operating earnings for the 500 index in 2006. An examination of the red “earnings” line in the chart above suggests that such robust growth in earnings on top of already all-time-high earnings would be a rare, if not an unprecedented historic event. In addition, it is difficult to believe that the consumer discretionary sector will grow earnings by more than 20% in 2006 after already posting such robust growth for an extended period of time. Earnings growth projections from other sectors appear to be similarly aggressive.

In order to ground-truth the S&P operating projections presented above, I compiled on an excel spreadsheet, Wall Street analysts’ 2006 sales growth projections as published in Yahoo Finance for practically all of the component companies in the S&P 500 index. If you send me an e-mail, I will be glad to share this data with you. The arithmetic projected sales growth rate for the S&P component companies averaged 7.2%. Accordingly, it appears that S&P is projecting 11.6% operating earnings growth to be achieved on projected sales growth of about 7.2%. These projections appear to be quite aggressive and perhaps difficult to believe. If such aggressive projections are not achieved, the next big move in the stock market will probably be down.

Today’s Market

While the aggressive sales and profit estimates by S&P are a bit hard to believe, as with any analysts, you sometimes have to give them their due. S&P’s 2004 edition of the “500 Guide” warned investors about the now bankrupt Delphi Corp:

”The shares offer an above average dividend yield, but we believe total return will be sufficiently negative to justify selling the stock.”

The stock market finished neutral today having churned on high volume. The bond market rallied, while economic data showed benign inflation. That pop in the gold and silver market said otherwise in no uncertain terms! The game is to tell the public that inflation is benign while attempting to keep interest rates down. The assumption is that the public is too dense to question what they are being told by the presentation of economic data. With gold and silver rallying into new high ground, this strategy won’t necessarily work.

I’m invested in gold and silver and what I consider to be blue chip mining shares. The key word here is “invested.” They were both up decisively today, but I’m not counting my paper gains yet. The most significant message in today's action is to confirm that the secular trend in precious metals is now up, and these shares should be held. (And more trading shares bought on inevitable pullbacks).

With Cramer playing in the background, spot silver is trading at $8.05/ounce. Silver has made it to this benchmark two times before in the last three years before it was whacked hard both times. So will this happen again? Maybe, but what is different this time is that silver is approaching its high while setting up a 6-week base. This shorter 6-week base is on top of an approximate 9-month base where silver ranged between $6.80 and $7.50. The two times it happened before, $8 silver was reached in a parabolic and emotional move that was subject to failure.

Homebuilders and retailers caught a bid today, while oil and oil shares were up. As you can see from the chart below, homebuilders caught a bid (on Horton home's good news), but the DJ homebuilder index is far from healed.

With S&P projecting “business nirvana” in ’06 as described above, I can’t help but wonder if this is not the selling opportunity of a generation. That’s what my left brain is telling me. My right brain is reminding me that entry points, stop losses and careful money management need to prevail to be successful. Oh…and the precious metals market is confirming the feelings of my left brain.

Have a great evening.

Martin Goldberg

Copyright © 2005 All rights reserved. Martin F. Goldberg, MS, P.E. Market Analyst Expert Page Commentary Archive Email

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