USA, Inc.: Have Profits Peaked?

As we emerge from the most severe recession in a generation, corporate America is back! U.S. companies have been beating estimates and raising guidance, forcing analysts to raise their estimates in order to keep up. It's an impressive performance, but it has sown the seeds of earnings disappointments -- and stock declines -- over the next few quarters. Let me explain why and I'll follow up with some suggestions on how best to position your portfolio now.

First, a little background. The following graph shows corporate profits as a percentage of U.S. Gross Domestic Product (GDP) from 1948 through the first quarter of this year:

Source: Bureau of Economic Analysis.

Note that this profit ratio doesn't trend in a single direction; instead, the average (the green line) appears to exert a sort of gravitational pull on the series: Periods of below-average values are followed by periods of above-average values. That's an established property of profit margins (aka "mean-reversion" to statisticians).

The crisis in focus
Let's focus in on the period from 2007 through the first quarter of this year:

Source: Bureau of Economic Analysis.

There are two phases here:

• The profit ratio begins to decline in 2007, but the failure of Lehman Brothers causes a sharp drop during the fourth quarter of 2008, which is the crisis low value (well below the long-term average).

• The profit ratio begins to recover in 2009, and by last quarter, it was back up above the average -- in fact, it has nearly recovered its 2007 high (well above the long-term average)!

The fact that we are already back at this level of profitability is a strong testament to the exceptional flexibility of the U.S. economy. In the wake of the Lehman bankruptcy, companies cut costs ruthlessly, boosting profits. No surprises there, except in terms of the magnitude of the impact.

What goes up must come down
However, the consequence of this recovery in profits to near-record highs is that margins now have very little upside and plenty of downside. In a client report dated June 18, Andrew Smithers, the head of asset allocation consultancy Smithers & Co., wrote that margins "are likely to fall a lot."

These observations fly in the face of the estimates produced by the analysts who follow individual stocks. Yesterday, Bloomberg reported that, based on 8,000 estimates, analysts now expect the earnings of S&P 500 companies to rise by 34% in 2010, compared with an estimated increase of 27% on March 29 -- the largest upward revision during any quarter in at least six years. That sort of increase looks inconsistent with profit margins that are already at or near their peak.

Something has to give
It's a small wonder then that Mohamed El-Erian, the CEO of bond fund manager PIMCO, wrote at the beginning of this month that "the second-quarter increase in analyst estimates reflected in part an extrapolation of the cyclical bounce into a durable, robust recovery ... We expect analysts to revise down their estimates in the weeks ahead ..."

Defensive, high-quality, and cheap is ideal
The tangible risk of earning downgrades and misses reinforces my conviction in the "high-quality/defensive" theme I have been hammering on about for a while. As the economy slows, companies that are less vulnerable to a slowdown should command a premium. Happily, some of the world's greatest "franchise" companies are now trading at discounted prices instead. They include:

• The world's largest retailer, Wal-Mart (NYSE: WMT), which trades at 12 times this year's earnings. You might prefer to shop at Target, but shopping for this stock should provide investors with a pleasant experience.

• Swiss health-care giant Novartis (NYSE: NVS), which trades at 10.5 times this year's estimated earnings for 2010 and yields 3.5%.

• It's not a defensive stock per se, but at 9.5 times this year's estimated earnings, Hewlett-Packard (NYSE: HPQ) shares compensate investors generously to look past quarterly earnings volatility.

Cyclical and expensive is suspect
Conversely, investors should be wary of stocks that:

1. Are in cyclical industries.
2. Are expensive on a historical basis or relative to their peers.
3. Have been the subjects of large earning estimate upgrades.

... and investors should be particularly careful when handling stocks that fall into all three of those categories, such as:

Source: Capital IQ, a division of Standard & Poor's.
*P/E multiples are based on the closing values on July 2, 2010, and next 12 months' EPS estimate.

In their haste to catch up with accelerating earnings, analysts have overshot regarding their estimates for the rest of 2010 and 2011 at a time when profit margins are already near historical highs. Once analysts are forced to lower these estimates and/or companies miss expectations, it will put downward pressure on stock prices. Under those circumstances, the safest segment of the market will be high-quality companies in defensive industries.

If you're concerned about the effect of slowing growth and ballooning government debt on U.S. stocks, there are alternatives for your money. Tim Hanson explains how to make more in 2010.