The earnings season for the first quarter kicked off this week. Analysts are looking for solid earnings growth in the first quarter, but that growth is built on two weak pillars: Anomalous sales growth and above-normal profit margins. Forward-looking investors should position themselves defensively, in case those pillars start to crumble -- as seems likely.
Estimates: Earnings growth to remain impressive!
Analysts are forecasting first-quarter earnings-per-share growth for the S&P 500 of 14.4% year on year. That represents a slowdown relative to prior quarters, but that's normal because the recovery is now relatively mature (in terms of duration; unfortunately, it's still fragile).
Surprisingly, the top-down earnings estimate for this quarter is actually higher than the bottom-up estimate. Top-down strategists tend to be more conservative, perhaps because they are more sensitive to the fact that margins for the U.S. don't stray too far from their historical mean (more on this below). Meanwhile, the bottom-up estimate is simply the sum of analysts' estimates for individual companies, which contain a bullish bias.
Note that the bottom-up estimate for the second quarter is greater than its top-down equivalent, and that is the case for every quarter through 2012. What are macro strategists anticipating that equity analysts aren't seeing? Here are few ideas:
Future sales growth estimates looks fragile
With expected year-on-year sales growth of 13%, analysts expect sales to be the main driver of earnings growth. By my reckoning, the estimates imply that two sectors will contribute an outsized chunk of the S&P 500's growth in the first quarter: energy and financials. Can we count on that over the medium term? The energy sector is cyclical; right now, the price of oil is at new highs and companies are booming. However, "cyclical" means that a bottom lies waiting for every top.
Similarly, financial institutions have been operating in an extraordinarily advantageous environment, with short-term interest rates at zero. Those conditions aren't sustainable. The European Central Bank started hiking rates last week, and the Federal Reserve will do the same at some point. If the yield curve flattens, revenues from traditional bank lending and other operations will contract.
Another way to put that 13% sales growth estimate in perspective: From 2000 through 2010, the S&P 500's sales grew at an annualized rate of just 2.2%.
Margins: Lower, but still at historically high levels
While analysts don't expect the earnings margin to contribute much to earnings growth, at an estimated 8.4%, it remains at the high end of its historical range. Still, that figure has come down from the margins achieved during the prior three quarters.
The average 12-month earnings margin for the S&P 500 going back to 2000 is 7.3%; that represents a 16% haircut with respect to the 8.7% margin that was achieved in 2010. Crudely applying that discount to Tuesday's closing price for the S&P 500 implies a value of roughly 1,100.
A basket of "protected" stocks
If earnings growth is unsustainable, but the market thinks we are due more of the same over the next two to four quarters, it makes sense to position your portfolio defensively. I want to come back to the notion of "protected" stock that I described here.
The idea is to identify stocks that are less likely to suffer compressed margins over the next few quarters, because their margins are already low by historical standards. ("Protected" does not imply that investors can't suffer losses by investing in these stocks. All equities are risk assets.) I have refined my screen to three criteria:
- Current earnings margin is low by historical standards (bottom quintile for the prior 10 years).
- Margins are historically stable. This excludes stocks that currently have low margins because they are undergoing fundamental changes in their business or that are highly cyclical.
- Price-to-earnings multiple is low or in line relative to the historical average (in the bottom three quintiles over the prior 10 years).
Based on this screen, I have put together a basket of 10 stocks in the S&P 500 that I believe will beat the index in a range of economic scenarios, but particularly if margins come under pressure. The basket is relatively well diversified across sectors:
Normalized Earnings Margin: Last 12 Months/ Average
Illinois Tool Works
International Game Technology
|Sealed Air||Consumer goods||5.4%/6.3%|
Source: Capital IQ, a division of Standard & Poor's.
Am I certain that earnings growth in 2011 will decline faster than the market expects? No, but I think the odds favor it and investors should position their portfolios accordingly. If you think differently, I'd be interested why; give me your reasons in the comments section below.
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