S&P 500 Profit Projections By Standard & Poor's Are Too High, Lower Prices Expected

Includes: CIU, HYG, IVV, JNK, LQD, SPY
by: StopAlerts

We are bears at this time. Even though there is the possibility of stocks rising in the near-term, we believe the weight of evidence suggests they will decline.

In addition to the slowing world economy, the generally lousy macro-economic situation in the U.S., the eurozone, and the slowing economy and potential banking problems in China, the profit outlook for U.S. companies in 2012 is not good in our view.

While the consensus is still for 2012 operating earnings in the $110 area, we think that is unlikely.

Even without a recession, which is a possibility, we think profit growth will slow and margins will compress, resulting in a lower profit outcome. Should a recession arise, profits could easily drop 10% to 20% or more.

Operating margins are well above mean and cannot be sustained for a long-time at such high levels, in our view.

Slowing profit growth (or decline) and a margin squeeze is unlikely to result in earnings multiple expansion, and probably would result in multiple compression.

S&P 500 Earnings

The profit projections for the S&P 500 seem unreasonable in the context of the macro-economic problems around the world.

Click to enlarge

It is not reasonable, we believe, to assume that U.S. profits will rise strongly from today through next year, as this chart of S&P 500 earnings from Standard & Poor’s indicates. It could happen, but we think the odds favor a flatter to declining earnings outcome.

Corporate operating and reported profits as of 2011 Q2 are at the same level as for 2007 Q2. Profit margins today are well above the long-term mean, and profits growth has been at a very high rate since 2009.

The growth cannot be repeated anytime soon, because it occurred from a major trough, and the world economy is now slowing.

The profit margins are the result of refinancing balance sheets at unsustainably low interest rates (which also took interest earnings from the pockets of consumers), and from above mean labor productivity made possible by the high unemployment level. Unemployment may persist, but labor is stretched near to limit.

BB - AA U.S. Corporate Bond Yield Spread

The yield spread between BB junk and AA quality corporate bonds is higher than it was at the time of the 2008 crash and the time of the May 2010 correction. Wider spreads mean worse expected economic conditions ahead.

Click to enlarge charts

Unlike the spread between investment quality corporates and Treasuries, which is more the result of falling Treasury rates, the widening spread between junk and investment grade corporates is the result of the yields on junk rising while the yields on investment grade bonds are relatively flat.

St. Louis Financial Stress Index

The St. Louis Fed publishes a stress index that considers many economic factors. A higher stress level is negative for the economic future. The stress level is higher than it was in May of 2010, and about where it was at the end of 2007. That is also a negative harbinger for corporate profits in the U.S.

Short-Term S&P 500 Price Probability Range

With the VIX at about 43, the price probability range for the S&P 500 for the next 30 calendar days at a 90% probability level is 927 to 1380, as shown on the following chart.

Note that fat tails are not in the math of price probability cones, and there certainly is the risk of fat tail events in the next few months.

Volatility based price probability projections are non-directional, but our view is directional. We hope 927 will not materialize in the next 30 days, but that is what options players have factored into the pricing of their bets should things go strongly negative.

The red lines in the chart mark the 10%, 15% and 20% offsets from the 1-year trailing high price. The blue parabola plots the 90% probability range for the price of the index over the next 30 calendar days based on an options implied volatility of 43%.

Click to enlarge

Related Recent Articles

Related Securities: SPY, IVV, JNK, HYG, CIU, LQD

Disclosure: StopAlerts.com is a service of QVM Group LLC, a registered investment advisor. As of the creation date of this article, QVM has no long positions in any mentioned security in any managed account as of the creation date of this article. QVM holds near-term, far out-of-the-money cash secured PUTs on SPY.

This article provides opinions and information, but does not contain recommendations or personal investment advice to any specific person for any particular purpose. Do your own research or obtain suitable personal advice. You are responsible for your own investment decisions. This article is presented subject to our full disclaimer found on our site available here.