Earnings forecasts still too high, but valuations remain attractive
Europe’s debt crisis has prompted downgrades to US economic and earnings growth forecasts, but even after adjusting for slower growth, valuations remain compelling and suggest scope for moderate equity gains this year.
In the wake of the euro-zone debt crisis, our forecasted range for 2011 US GDP growth is 1.8- 2.3%. On this basis, our analysis suggests earnings growth will slow to a range of 10-12%. This has already been partly reflected in a moderation in consensus forecasts for profit growth from around 20% to 17.7%. Based on current prices, our forecast suggests the price-to-earnings ratio (P/E) for end-2011 would be between 12.6 and 12.9, compared to the current 11.7. Such a modest increase would still be well below the long-term average P/E of 16.8 for the MSCI US Index. This implies room for further gains in equities even if our slower-growth forecast is correct.
In order to estimate the impact of slower GDP growth on corporate earnings, we used a linear regression model of GDP growth against equity market returns and earnings-per-share (EPS) growth, beginning from 1968. Initial results suggested some correlation, but not to a satisfactory level. The accuracy of the model was improved by removing any outliers of greater than two standard deviations, or roughly 16% of the total observations. This led to the model correctly predicting earnings growth from a given GDP figure about 50% of the time.
We back-tested the model to see how well it predicted earnings growth during past recessions and found that it had a bearish bias of approximately 8 percentage points during recessionary periods. This is due to the fact that the model takes in to account observations over the whole period of 1968 to date, while recessions cover select periods averaging 5 quarters and tend to have a ‘base effect’ that needs to be accounted for. In other words, growth tends to be much stronger in the aftermath of recessions, because it is starting from a lower point. Taking our estimated range of 1.8-2.3% US GDP growth in 2011, and adjusting for the ‘recession bias’, our model predicts a range for earnings growth of 10-12%.
Our model implies that the consensus forecast of 17.7% EPS growth would require annual GDP growth of nearly 6% (see the chart above). This implies that the US equity market is pricing in a much more optimistic view for GDP growth than the consensus forecast of economists.
The fact that consensus EPS growth forecasts have been revised lower for the past 5 consecutive weeks suggests the equity market is starting to price-in a more muted economic recovery, and we believe further downgrades for EPS growth are likely.
Although this could weigh on sentiment in the short term, even these lower growth forecasts would leave room for further gains from current levels in the months ahead. Applying the model to equity returns also suggests a modest positive return for this year and in 2011.
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