Global Profits Recession?

S&P 500 EPS earnings fell 5.6% in Q3 2007 and current consensus estimates suggest Q4 is likely to be down double-digits (Figure 1). For the year as a whole S&P 500 firms will be lucky to eek out a gain at all.

But of course the real question is of course what happens to earnings this year. Current estimates envision a 15% gain, but this could prove wildly optimistic. It would be without precedent for S&P 500 earnings to decline two consecutive quarters (as they did in Q3-Q4) and not precipitate a more prolonged profits recession.

We are already seeing signs of a spillover effect: financial firms are one of the biggest buyers of tech equipment, and tech executives have started blaming missed estimates on weakness in capital spending and the like. Meanwhile holiday sales were disappointing and even luxury retailers such as Tiffany’s have fallen short of expectations, so expect Consumer Discretionary firms to start lowering profit expectations too.

How bad could it get? At inflection points such as this consensus estimates are of little use but history may provide some insight. Since 1950 S&P profits have oscillated around a consistent, long-term trend line which suggests that were the current high level of profits to simply fall back to trend they would be about 24% lower than currently forecast (Figure 2). That, in turn, implies that the real P/E ratio for 2008 is closer to 19x as opposed to the 14x using current consensus estimates.

Unfortunately, steering clear of the U.S. may offer little immunity. Estimates for companies in the iShares MSCI EAFE fund (EFA) of developed-economy stocks appear to have rolled over after being revised higher for most of the year (Figure 3). Perhaps not surprisingly, Financials were the main culprit. Our sense is that while we may very well see more write-offs in the U.S. from the sub-prime mess, the proverbial “other shoe to drop” will be abroad, and it will come from two sources: belated recognition by foreign institutions of losses on U.S. mortgage debt, and imprudent lending by foreign institutions themselves (especially in the U.K., where consumers are even more indebted than their American counterparts and where the housing market is just beginning to weaken).

Significantly, we have not yet seen estimates decline for firms in the iShares MSCI Emerging Markets fund (EEM), which has a bit less exposure to Financials. But if global demand for natural resources declines as a result of a profits recession, the Energy- and Materials-heavy emerging markets index could also see estimates slashed. In short, what has been a synchronous global boom in recent years could, unfortunately, turn into a global bust. Happy New Year.