EQ: Optimists seem to be pinning a lot of hope that the Federal Reserve will announce some form of economic support or stimulus plan on Friday. What do you think the likelihood is that the Fed is ready to step in? And if they did, would it make much of an impact at this point in time?
Stovall: People are hoping that the Fed will say anything that can be regarded as constructive or supportive of the economy, thereby having a positive impact on equity prices. Too many people are now getting worried that we are edging closer and closer to a new recession. Even though investors were pleased that the Fed indicated that they will likely keep interest rates at current levels until 2013, they're hoping that we'll get even more information as to what the Fed may do when Bernanke speaks on Friday. We don't have a lot of ideas as to what specifically he might say, but last year he really didn't say much more than that the Fed will be doing whatever it can in order to support the economy. People seemed to be very pleased with that statement. We might find that a similarly unspecific statement would be enough this time around, yet we believe people will need even more detail to feel encouraged. I think that a favorable comment by Bernanke, combined with some actions by the U.S. Congress that show they're willing to work in concert, would go a long way in supporting investor concerns.
EQ: In your Sector Watch report this week, you detailed how we could use historical operating EPS to give us an idea of where the S&P 500 could potentially bottom if we did enter a recession. Can you discuss what you found?
Stovall: Even though we currently are not projecting that a recession is the most likely scenario, we have to be aware of the possibility. If 2008 taught us anything, we have to be proactive and expect the worst. With that in mind, I looked back to 1948 to see how much earnings tend to decline during recessions, and therefore, what kind of erosive effect could there be on current earnings. What I found was that the average decline in earnings is anywhere from 15 percent to 20 percent. While the stock market does tend to anticipate recessions by seven to eight months, it anticipates earnings peaks by one to three months, implying that the June quarter might have been the peak for this economic cycle.
If that is the case, and it's certainly an "if" situation, that implies that earnings could probably fall from the low $90s, to the mid-to-high $70 range. If you also apply the average P/E ratio during recessionary times--which was 12x to 13x--we come up with a target decline level for the S&P 500 of between 900 and 1030. So the implication is that we could see a garden variety bear market, which means a little above a 30-percent decline, which would be fairly consistent with history, and probably means we would not need to retest the lows of 2009.
EQ: There was a recent New York Times that asked why Wall Street economists are slashing GDP projections but equity analysts are not doing the same with earnings estimates. Based on your observations, do you find this to be true? And why do you think that is happening?
Stovall: Yes, I've been seeing that economists have been more proactive in cutting their GDP estimates. As of March of 2011, S&P Economics was projecting that we'd see a 3.1 percent increase in real GDP for all of 2011. That estimate is now cut to 1.7 percent. Also back in March, they thought we'd see 3 percent growth in 2012. That number has now been whittled down to 2 percent. We're seeing declines anywhere from 33 percent to almost 50 percent reductions, so economists certainly are trying to get in front of the curve.
What's causing the analysts to be a little slow in bringing down their estimates? It could be a combination of things. First, it could be guidance, or lack thereof, from management that is causing analysts to maintain their elevated targets. Also, remember that 50 percent of the revenues in the S&P come from overseas operations. So there's the possibility that even though the U.S. is likely to see a 1.7 increase in real GDP in 2011, global GDP could rise by 3.1 percent in 2011, as projected by Global Insight, an independent economic consulting firm. So while earnings estimates have began to come down, they've not come down as quickly as U.S. GDP estimates, possibly because of the global nature of earnings as compared to U.S. GDP.
EQ: Could that discrepancy in earnings estimates have a drastic impact on the market and investors?
Stovall: I think the market is already anticipating a reduction in earnings. We have already seen an 18-percent price decline in the S&P 500 from peak to trough during this correction. Historically, the market has declined anywhere from 22 percent to 30 percent--22 being the median and 30 being the mean decline, since 1948 in anticipation of recessions. So the market is already building that into their estimates. With P/E ratios already between 12x and 13x, the only part of the equation missing is an eroding forecast. With Wall Street already anticipating that, should we start to see a decline in earnings, it will probably be less of a shock.
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