1 Contrarian Call Worth Heeding

I'm on record saying I think the S&P 500 will miss its 2012 operating earnings-per-share forecast of $107. I'll go further still: I think earnings will decline in 2012. Read on and I'll give you some evidence to support my bearish stance, along with four stock ideas in a sector that I expect to escape that trend.

The trend is broken
As earnings season gets under way, let's first take a look back at how the S&P 500 (operating) earnings estimate for the fourth quarter evolved over the past 15 months:

September 2010

December 2010

March 2011

June 2011

September 2011

December 2011

$21.56

$21.93

$22.56

$24.86

$25.29

$24.31

Source: S&P Capital IQ.

It's pretty remarkable that the estimate kept on rising through the summer, even as the stock market started convulsing in response to the European sovereign debt crisis. Finally, as the fourth quarter began to unfold, reality -- and consequently realism -- asserted themselves and the estimate fell to slightly below its level in June.

Estimates for 2012 earnings also came down during the fourth quarter, from $111 to $107. For anyone who has put out a forecast for the level of the S&P 500 index at the end of 2012, it's worth tracking this number, since earnings growth is one of the key drivers of equity returns (in fact, it's the key driver over long time horizons).

From top-down to bottom-up
My bearish view on earnings is based on a top-down observation: Profit margins must revert to the mean from historical highs, which is where we are now. From a bottom-up perspective, we noted that the earnings estimate had come down in the fourth quarter. Here is the evolution of the relative proportion of downward revisions to upward revisions by analysts for the companies in the S&P 500:

 

December 2011

November 2011

October 2011

Ratio of downward revisions to upward revisions, S&P 500* (2012 EPS)

1.7 : 1

1.1 : 1

1.6 : 1

Total number of revisions

1,941

1,361

2,740

Sources: Author's calculations based on data from S&P Capital IQ. *Subset of S&P 500 companies with fiscal matching the calendar year: 404 companies, representing four-fifths of the index's market value.

In November, the number of downward revisions fell so that it only slightly exceeded upward revisions. However, that ratio shot up again in the final month of the year, with almost twice as many downward revisions as upward revisions. Even with November showing some improvement, the total number of earnings estimate revisions was significantly lower than in October and December. The result? For the quarter as a whole, there were three downward revisions for every two upward revisions.

Financials: time for redemption
I'm more bearish than the consensus regarding the index, but not uniformly so; one opportunity stands out. Of the top 10 companies in terms of percentage increase in their 2012 EPS forecast in December, half are financials, including Bank of America (NYSE: BAC  ) and Morgan Stanley (NYSE: MS  ) , as well as two regional banks, Hudson City Bancorp (Nasdaq: HCBK  ) and SunTrust Banks (NYSE: STI  ) . Analysts are warming to these stocks, and investors will follow. Barring a collapse of the European banking system, I think all of these stocks will outperform this year (or failing that, over a three- to five-year time frame, which is, after all, the minimum expected holding period for equities).

These stocks are representative of one of my favorite themes for the year: On the heels of a brutal correction in 2011, I believe that the financial sector and regional banks will outperform the market in 2012. Here is my CAPScall. I will be assigning an outperform rating to the bank stocks mentioned above, along with the SPDR Financial Select Sector ETF (NYSE: XLF  ) and the SPDR S&P Regional Banking ETF in CAPS. I'll be tracking the success of these calls here; everyone else can, too. (Interested in several carefully vetted bank stock ideas? You'll want to read "The Stocks Only the Smartest Investors Are Buying.")

Once bitten, twice shy
Readers -- those who leave comments for my articles, at least -- appear to be adopting a "once bitten, twice shy" attitude to bank stocks (with regard to one megabank, in particular). I think extrapolating recent experience is a mistake and will cause investors to miss what I believe is one of the best sets of opportunities in the current market. Agree or disagree? Let me know why in the comments section below -- I'm listening.

Fool contributor Alex Dumortier holds no position in any company mentioned. Click here to see his holdings and a short bio. You can follow him on Twitter. The Motley Fool owns shares of Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 12, 2012, at 4:14 PM, TMFSpiffyPop wrote:

    Great job making CAPScalls, Alex -- keep up the superior, transparent, accountable work.

    Foolishly,

    David

  • Report this Comment On January 13, 2012, at 3:22 PM, Teacherman1 wrote:

    You may not agree with all my choices, but I like bank stocks too.

    25% of my CAPS (ie real life) picks are banks.

    I find that buying them at a low price helps a lot.:)

    As soon as we get the Q4 news out of the way, I will be posting much more detailed information on the stocks I own, and why.

    Of course, as a warning to anyone who might think I know anything. I also like shipping stocks.:)

    Good article, and good luck in the coming year.

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