In keeping with the trend of recent years, the new year is off to a good start, and according to Barron's, analysts are forecasting 10% earnings growth during 2013 for the S&P 500 (SPY). A 10% increase in S&P 500 earnings translates to approximately $114. The S&P 500 is presently trading at approximately 1500 or 13.2 times forward earnings, based on these projections.
Given that 2012 actual earnings are estimated to have increased approximately 5% to around $102.50 according to Barron's and recent earnings estimates have been revised lower, the market is probably relatively suspect of these projections.
According to work conducted at NYU's Stern, the historical EPS growth rate for the S&P 500 since 1960 is less than 5%. If we use a 5% EPS growth rate for 2013, we get S&P 500 EPS $107.50. Using the historical average PE multiple of 15, that takes the S&P 500 to 1612, approximately 7.5% higher than where we are trading today.
I believe that 1612 is a reasonable base case expectation for the S&P 500 during 2013. Recognizing that expectations are seldom accurate, we use S&P 500 1612 as a starting point.
Foremost, while the S&P 500 could trade at a 15 PE multiple as a result of global central bank liquidity programs, in my view, for the S&P 500 to justify a 15 PE multiple, the US economy is going to have to be strong enough to withstand an end to the Fed's asset purchase programs. The economy also needs to be strong enough to anticipate and withstand an ensuing cycle of interest rate increases.
Without an end to the asset purchase programs, I am doubtful that the S&P 500 can sustain a 15 PE multiple. Using a 12 PE multiple, even with 5% EPS growth in 2013 to $107.50, the S&P 500 price becomes fairly valued at 1290, roughly 14% lower than where we are trading today.
Just as the US economy makes mild improvements, new problems seem to pop up which prevent the Fed from taking an aggressive posture toward ending the asset purchase programs. The problem at the moment appears to be continued deterioration in Europe. In the most recent economic reports from the EU, unemployment continued to rise, industrial production continued to decline and stalwart Germany reported a contracting GDP number during the fourth quarter of 2012. The US recently reported a decline in Q4 2012 GDP.
If the US economy can continue along the current 2013 trajectory, in spite of Europe and the debt debate here in the US, I believe that the Federal Reserve needs to begin reducing its asset purchases as soon as possible. In my view, there has been and continues to be a window to begin reducing liquidity, and I am hopeful that the window does not close, leaving the US vulnerable to an economic decline resulting from normal business cycle forces, or worse, an unexpected shock to the US or global economy. I am also worried about how the rising rate cycle will impact earnings for our businesses and thus the future prices for our shares. I am working on the analysis.
Given the vast liquidity being provided by US and global central banks, combined with the fact that the Fed does not seem interested in ending the asset purchase programs anytime soon, the potential exists for continued stock market upside. It is possible that the S&P 500 can actually deliver 10% EPS growth (or better) during 2013. As a point of reference, a 15 PE on $114 S&P 500 EPS yields an S&P 500 price of 1710, approximately 14% higher than where we are presently trading.
Our aim is to take a balanced approach, and as such, it is essential to review the downside. I have been worried about inflation for a while now, and in my estimation, we have experienced pockets of inflation in recent years (see the Bureau of Labor Statistics). As anecdotal evidence, rents have increased; employees in many industries are demanding and receiving higher wages; prices for utilities and other basic services such as electricity, water and television are on the rise; automobile prices are higher, home values and mortgage interest rates are climbing, making real-estate payments and property taxes higher; airline tickets, hotels and other fees have made travel more expensive; and food and gasoline prices have increased considerably in recent years.
Our goal is to own businesses which are profiting from these price shifts and to avoid those businesses which are unable to adapt profitably to the changes.
With the ten year US treasury still yielding around 2%, the bond market is not yet convinced that the US economy is out of the woods, nor does it appear that the bond market sees a clear end to the Fed's asset purchase programs. We do not own any bonds for our portfolio at the current prices.
While I can only provide the anecdotal evidence mentioned prior, in my opinion, we have clear pockets of inflation taking hold. The recent rise in US income taxes will take a bite out of consumer paychecks and worry over the US debt & deficits potentially combined with more contraction in Europe, could cause the current economic optimism to wane. I hope that we can maintain the current optimism, but I recognize that hoping can be a costly investment strategy.
The US deficit and debt reduction initiative presents an enormous opportunity for our country. However, if no constructive measures are achieved, save the recent tax increases, the US faces a long term fiscal headwind that cannot be taken lightly.
Under a scenario where US business conditions deteriorate during 2013, a 12 PE multiple on $90 EPS prices the S&P 500 at 1080 or 28% lower than where we are presently trading. A rapid deterioration in economic conditions would lead to an even lower price for the S&P 500.
Since no one can foresee the future, we entered 2013 fully invested with an optimistic base case outlook. We have continued to prepare our portfolio through diligent evaluations of the businesses that we own. As well, we continue to conduct analysis of businesses that we could potentially own during 2013. These strong efforts ready us for any eventuality.
Sources: Barron's 12/17/2012; Bureau of Labor Statistics; NYU Stern