Profit Outlook Questioned

1/4/2010


Economic reports and profit news will dominate near-term trading, as investors are likely to react harshly to any indications that expectations for 2010 are overly optimistic. For now, we’re holding 20% to 25% of equity portfolios in a short-term bond fund as a hedge.

Great expectations

Consensus estimates project U.S. gross domestic product (GDP) will grow 2.7% in 2010 after shrinking 2.4% in 2009. While economic growth of 2.7% would represent a big improvement, the first year of an economic recovery typically sees much faster growth. Reflecting consumers’ debt-heavy balance sheets, sluggish income growth, and reduced access to bank loans, most economists are forecasting a subpar recovery.

Investment strategists, meanwhile, are forecasting a brisk recovery in profits. Consensus estimates project the profits of companies in the S&P 500 Index will climb 27% in 2010 and 21% in 2011, which would represent the fastest two-year increase since 1986 to 1988. For 2010, the ratio of expected profit growth to expected GDP growth is the highest on record, according to data from Bloomberg going back 60 years.

Profits for the S&P 500 financial sector are expected to surge 172% in 2010 as banks recover from massive loan losses. Reflecting expectations of higher commodity prices, earnings are expected to climb 45% for the energy sector and 75% for the materials sector.

Are such lofty forecasts realistic? Bulls argue that a sharp jump in profits is likely after one of the worst economic downturns since the Great Depression, while bears argue that the optimists are ignoring the considerable headwinds the economy faces.

If the optimists are right — and profit growth over the next two years meets consensus estimates — stock prices are relatively cheap versus historical norms based on expected 2011 profits. If the pessimists are right — and profits grow only modestly in 2010 and 2011 — the S&P 500 Index is somewhat expensive versus historical norms.

Conclusion

Many companies will provide guidance for 2010 when they report December-quarter results, so the coming earnings season could prove especially crucial. Stocks, especially those of economically sensitive companies, appear vulnerable to earnings disappointments for 2010. While we continue to recommend some economically sensitive names in energy and technology, many of today’s best values are in defensive areas like consumer staples and health care. Attractive names in these groups include General Mills ($72; GIS) and Hospira ($51; HSP).


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