Expectations Too High?


Consumer-confidence numbers are on the rise. But Americans are still plenty skittish, reflecting the worst job market in nearly three decades. Consensus estimates project U.S. gross domestic product will increase 2.7% in 2010, a fairly anemic growth rate for the first year of an economic recovery.

Yet total profits for the S&P 500 Index are expected to surge 30% this year. The average company in the S&P 500 is projected to deliver per-share-earnings growth of 13.4% for the 12 months ending September, which would rank among the top 8% of all 12-month periods since 1990. Those numbers sound great, but a little context clears up the picture.

Analysts are unusually buoyant. Estimated profit growth in the 2010-to-2011 period would represent the fastest two-year advance in more than 20 years.

According to Investors Intelligence, 53.4% of newsletters are bullish, versus just 15.9% bearish. The 37.5% spread between bullish and bearish newsletters is the highest in two years and nearly triple the average since 1989. With that kind of optimism in the air, it is easy to believe profit expectations are too high.

Unemployment doesn’t faze market

Because investors look forward, stocks often perform well amid downbeat economic news. In the 709 rolling 12-month periods since 1950, the average 12-month rise in the S&P 500 Index was 8.3%. However, after months when the unemployment rate was at least 8%, the index averaged a 17.3% gain. In contrast, the index averaged a 12-month rise of less than 3% after months when unemployment was below 5%.

This doesn’t mean that unemployment is good for stocks, but that stocks tend to perform well after periods when the economy is in trouble, presumably lifted by the recovery.

Job cuts can boost profit margins for individual companies, and for the market as a whole. In the September quarter, the S&P 500 Index’s operating profit margin rose to 6.9%, the highest level in seven quarters, helped by layoffs and other cost cuts.

Of course, layoffs cannot continue forever. The economy needs job growth to sustain a recovery, and Wall Street’s aggressive expectations suggest such payroll expansion is coming. However, economists expect unemployment of 10% or higher for most of 2010, suggesting moderate job growth at best.


Worried consumers and aggressive expectations make for a potentially combustible mix. While we continue to find attractive values like Aflac ($50; AFL) and IBM ($131; IBM), the risk of a broad-based correction suggests holding 20% to 25% of equity portfolios in a short-term bond fund is prudent.

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