Merrill's David Rosenberg Discusses Corporate Earnings and Market Multiples

Whatever the squiggly lines look like in the short run, and they're plenty squiggly today, now up sharply on some sort of financials-driven rally, the medium-term prospects for equities are driven by two things: corporate earnings and market multiples. On those all-important questions, here's Merrill's David Rosenberg, a confirmed member of the reality-based community:

Prospects for a profit plunge are palpable

In the final analysis, only two things go into the forecast for the S&P 500 -- earnings and the multiple that investors are willing to pay for that future earnings stream. While it is normal to see corporate profits decline 30% in a recession, what makes the current and prospective backdrop more sinister is that we headed into this recession with profit margins at sky-high levels. The ratio of pretax profits to nominal GDP has already started to recede from its nearby 55-year high of 14% as we headed into recession to 12.2% currently, but consider that recession troughs usually occur just south of 7% on this metric. If we overlay this with S&P 500 earnings per share, what we are then talking about is the strong possibility that profits end up being cut in half during this bear market -- which would mean an ultimate low of around $45 on operating earnings (in other words, we are only one-third of the way through the earnings turndown at a time when the consensus seems to priced for the bottom being right about now!).

Now to put this into some sort of perspective, the 4-quarter trailing EPS in the 2001 recession hit a trough of around $38 and in 1991 the trough was jut over $18 so we are not talking about Armageddon here but rather offering up some analysis highlighting the what the risks are the outlook. We will bottom at levels much higher than the troughs in the past, that is the good news. The not-so-good news is that the level of the S&P 500 in the past that tended to coincide with $45 earnings was right around the 1,000 mark; and if we were slap on a typical trough multiple of 10x-12x on that earnings stream, then...well, you do the calculation.

Either way, as economists judging the earnings landscape, it is extremely difficult for us to be calling for a bottom in this market outside of the intermediate oversold lows that are the domain of technical analysts and generally prove to be very temporary as we saw back in January and March of this year. One of the biggest fundamental hurdles to the market, we're afraid, is going to be the risk of continued negative earnings surprises, especially with the consensus predicting earnings growth of 13% the second quarter and 59% in the fourth.

Source

David Rosenberg, "Morning Market Memo," Merrill Lynch, July 7, 2008

Comments

[bbzz24]

all that good, but is the current environment similar to those of the reference recessions?
how about the amount of money that can possibly be poured in the markets given the present spending habits of retail 'investors'?
any adjustments to inflation which seem to be way off what the lousy bunch reports?
onee can go on an on.
what i see is 10 years of seesaw market movement and you see ever more promising corporate earnings. i smell fish here. it aint felix salmon's article though.

[The SimpleAccountant]

I tend to agree with Mr. Bbzz's comments, even though it's heresy for an accountant. The price of stocks and other financial does seem to move with the supply and demand for those assets, and there is a lot of liquidity seeking return, so I tend to doubt that there will be a disastrous decline from here in the broad equity indexes. Just a hunch, based on a trader's instincts.

However, I do think that Mr. Rosenberg has a valid point, as does his colleague at Merrill, Richard Bernstein, who suggests being in high quality bonds and blue chip equities. My own tendency is to think that large cap value, which has underperformed of late, will be a relatively stronger asset class going forward.