Disappointing Large-Cap Earnings Will Leave Small-Caps Vulnerable

Earnings season is just beginning, and low equity volumes and bland price action indicates a lack of interest, or at least conviction. A theme that increasingly interests me and, judging by my email box, some of the more astute researchers out there, is the seemingly inevitable sharp downgrade of US earnings expectations, which would presumably lead to lower stock prices.

While consensus expectations have been marked lower, they still imply stronger SPX earnings in 2008 than in 2007. How that squares with an inability to procure credit and a nascent shedding of labor is an issue that has frankly eluded me. What we can observe is that the gap in 12-month trailing earnings and the 12-month forward forecast has widened sharply recently. Now, part of this is the simple mechanical function of the forward "earnings year" shifting from 2007 to 2008...though even smoothing for that suggests a wedge is forming between trailing earnings and the forecast. (Click images to enlarge.)

Even more remarkably, analysts are forecasting stronger 12-month forward earnings now than they were a year ago. To be sure, the degree of optimism has waned considerably from its peak of a few years ago. But observe that in the last two recessions, y/y forward estimates turned sharply negative, reflecting the substantially lower profit base resulting from the economic downturn. On this metric, there is very substantial room for pessimism to increase and downgrades to emerge.

And if the SPX looks vulnerable to revisions, what about the less-covered small caps? Data is admittedly hard to come by here, and I am working with the scraps that I can retrieve from Bloomberg. (Any readers with good historical data on Russell trailing and forecast P/Es and who is willing to share, by all means contact me by email.)

But as the chart below indicates, trailing earnings in the Russell have collapsed over the past couple of quarters, which has pushed the trailing P/E up to nosebleed territory (53.3 according to Bloomberg.) But the earnings estimate data that I have been able to procure hasn't really budged at all.

If there's room for futures disappointment in the S&P, what should we be expecting for the small caps? Yesterday's survey of US small business confidence plunged to the lowest level in the history of the survey, which goes back to the mid-80's. Hardly a ringing endorsement of the small companies that represent the backbone of the US economy, is it? The large cap/small cap trade that we tracked in the blog portfolio has taken a step back over the past few weeks, as major indices have taken a breather and nudged higher. If the disappointment which appears to be forthcoming actually does materialize, both the SPX and especially the small caps look vulnerable.

Comments

[Jack K:]

Yikes!

2008 Apr 09 11:01 PM

[NOWHEREMAN:]

I look for the Russell 2000 to go down to the 550-600 area...while the small caps, in general, have a greater ability to go with the flow...they are far more nimble regardless of economic conditions...they lack the ability to raise capital in the present circumstances(private investment excluded).

So when push comes to shove, they will cut jobs the fastest..and we will all wonder why the jobless rate is increasing so rapidly.

Then the analysts will finally get the picture that their forecasts which all have to take in employment for earnings projections are totally incorrect...multiple downgrades galore....why? Because issueing BUY ratings on stocks whose prices are not justified occurred a few years ago. The resulting uproar still lingers. One analyst downgrade will trigger others.

Too bad the Dow doesn't include more commodity stocks but the addition of Chevron as truly helped it.

2008 Apr 10 10:50 PM