Earnings assumptions look over optimistic By Chris Tracey, investment director US investors ar...
Earnings assumptions look over optimistic
By Chris Tracey, investment director
US investors are clearly of the view that, the worse the economic evidence, the more reflationary the monetary and fiscal response will be, thereby ensuring that the recession will not be long and the recovery sharp. Third quarter GDP, at -0.4% annualised, was actually rather better than the consensus estimate of -1.0%, but these are very preliminary numbers and may get revised down. The economic statistics for September alone were dire, but given the disruption caused by September's terrorist attacks, such poor data may be exceptional. More worrying were the few statistics applying to October. The NAPM manufacturing survey, for example, suffered its largest monthly drop since the survey began in 1931. On the consumer front, confidence took another plunge, with the New York Conference Board Index falling much further than expected.
In the face of such weak economic data, the market expected the Federal Reserve to cut by another 50bps this cycle (which it did on 6 November). There is a chance of another 50bps in addition. Interestingly, by ceasing auctions of the long bond the authorities appear to be encouraging a flatter yield curve so that the impact of lower interest rates is better reflected in borrowings, such as mortgages, priced off the long bond.
On the corporate front, with 80% of companies having reported it looks as though third quarter operating earnings will have fallen by some 26% against the same quarter last year. Consensus estimates are for a 16% fall in the fourth quarter (in our view too optimistic), a 9.5% fall in the first quarter 2002, flat second quarter and a positive third quarter (+15%) and an excellent fourth quarter (+40%). Essentially, therefore, investors are buying US equities for a sharp recovery in profits in the second half of 2002. Such an assumption may well be right, but our reluctance to get too enthusiastic is twofold. Firstly, even on more optimistic assumptions than the above, it is very difficult to get the PER on the S&P 500 for next year below 20. Secondly, although equities are undoubtedly undervalued against government bonds, they are not against corporate bonds whose valuation is discounting a degree of distress in the credit markets, presumably related to cash flows and profits, which the equity market simply isn't. We remain neutral, but inclined to reduce if the rally continues.
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