Stocks Cheapest Since '89 Show Why Analysts Dismiss Economists

Never before have Wall Street stock analysts diverged more with economists at their own firms over the outlook for earnings in the Standard & Poor’s 500 Index.

Profits for companies in the S&P 500 will rise 25 percent next year, according to the average estimate of more than 1,500 equity analysts tracked by Bloomberg. That’s 10.9 times faster than the expansion in gross domestic product foreseen by 53 economists surveyed last month. The ratio of income to GDP growth is the highest on record and compares with an average of 6.1, based on data compiled by Bloomberg going back 60 years.

Concern that profits won’t measure up to estimates may limit returns after the S&P 500 rose 50 percent since March, the steepest rally in seven decades. While shares trade close to the cheapest levels relative to earnings since 1989, based on next year’s projections, forecasts for the economy by Goldman Sachs Group Inc.’s Jan Hatzius, Morgan Stanley’s Richard Berner and Bank of America Corp.’s Drew Matus show equities are no bargain.

“Earnings are going to be dependent on the overall economic growth,” said Barry James of Xenia, Ohio-based James Investment Research Inc., which oversees $2 billion and whose James Balanced Golden Rainbow Fund beat 98 percent of competitors over the past five years. “While things are not as bad as they have been, we don’t see next year as being one that will go gangbusters.”

Justifying the Rally

The S&P 500 retreated 1.2 percent last week after a report on factory orders and speculation that China would curb bank lending raised doubts about the speed of the economy’s recovery from the first global recession since World War II.

The S&P 500 climbed 0.9 percent in New York today after U.S. markets were closed yesterday. Investors returned from the Labor Day holiday after the benchmark index for American equities rose as much as 52 percent from a 12-year low on March 9 and the proportion of companies that beat analysts’ profit predictions matched a record.

The gains spurred the steepest rise in the S&P 500’s price- earnings ratio since at least the 1950s, pushing the index to 19 times operating earnings from the past 12 months, the most expensive level since 2004, according to data compiled by Bloomberg. Based on analysts’ forecasts for 2010, the S&P 500 trades for 13.5 times income, the lowest since 1989 when compared with the trailing P/E ratio before Lehman Brothers Holdings Inc.’s collapse a year ago.

Too Optimistic

The U.S. economy will expand at a 2.3 percent annual rate next year as the longest recession since the 1930s ends, according to the average estimate of economists surveyed by Bloomberg. U.S. companies are expected to halt a two-year slump in profits next quarter, the longest since the Great Depression, according to analyst projections compiled by Bloomberg.

While the individual forecasts may prove accurate, as a whole they are overoptimistic, based on economists’ expectations for U.S. growth.

Sal Tharani, Goldman Sachs’s analyst who covers metal producers, told investors to buy Phoenix-based Freeport-McMoRan Copper & Gold Inc. on Aug. 18, saying in a research note that higher metals prices will help 2010 per-share profits increase 48 percent at the largest publicly traded copper producer. Among the 14 companies he covers, Tharani’s stock picks during the past year have been more profitable than any other analyst’s, according to data compiled by Bloomberg.

Tharani was unavailable to comment, said Ed Canaday, a spokesman for the bank.

‘Conviction Buy’

Goldman Sachs, Wall Street’s most profitable investment bank, added Freeport to the “Conviction Buy List” of stocks it expects to rise the most. The firm predicts copper prices will climb 34 percent next year. Futures linked to the metal have doubled in New York trading so far in 2009.

Freeport will have to reach that profit target without the help of an economy expanding faster than about 2 percent next year, according to the growth forecast from Hatzius, Goldman’s New York-based chief U.S. economist.

Consumer spending will be weaker than at the end of previous recessions, Hatzius wrote in a Sept. 1 note. He doesn’t have a prediction for earnings growth and declined to comment on analyst estimates in a Sept. 4 interview.

Ken Hoexter, an analyst at Bank of America in New York, says Union Pacific Corp. should be able to raise prices in 2010, boosting annual earnings by 21 percent at the largest U.S. railroad by market value. Hoexter, the second-best stock picker in the past 12 months among the companies he covers, has rated Omaha, Nebraska-based Union Pacific a “buy” since March 16.

Freight Hauling

Union Pacific’s sales are stabilizing after falling 28 percent in the second quarter as the recession curbed freight hauling, Hoexter said.

Demand will have to rise while the U.S. expands at a 2.5 percent annual rate, according to Drew Matus, a New York-based senior U.S. economist for Bank of America. Hoexter and Matus were unavailable to comment, according to Susan McCabe Walley, a Bank of America spokeswoman.

Stephen Richardson, an energy analyst for Morgan Stanley in New York, projects 52 percent sales growth for Apache Corp., the biggest independent U.S. oil producer by market value, more than doubling the company’s profit.

Apache, based in Houston, will earn $11.56 a share next year as it raises production and reduces costs, according to Richardson. That’s the second-highest analyst estimate among 26 in a Bloomberg survey and 32 percent more than the average.

‘Shocking Number’

“It is a shocking number,” said Richardson, whose firm expects oil prices to average $85 a barrel next year, or 51 percent above its average so far in 2009. “Oil’s a global market. You don’t necessarily need very strong U.S. demand for oil prices to be above where they are.”

His estimate for Apache’s profit growth is 56 times greater than the 2.6 percent U.S. economic expansion foreseen by Berner, the co-head of global economics at Morgan Stanley in New York. Consumer spending may struggle as U.S. households save more amid declining employment levels and wages, Berner said on Aug. 7.

That will limit earnings growth for U.S. companies to about 12 percent, Berner said in a telephone interview last week. A 25 percent jump in overall profits “seems improbable,” he said.

Analysts who foresee earnings outstripping the U.S. economy are counting on growth in international markets to make up the difference, said Fritz Meyer, the Denver-based senior market strategist for Invesco Aim, which oversees $149 billion.

“You want to hear managements talking about demand across the world,” Meyer said. “Earnings forecasts as they’re currently stated are achievable. I wouldn’t be surprised to see upward revisions.”

Fewer Opportunities

Companies that boost earnings through expense reductions may find fewer opportunities to cut costs next year, according to Joel Naroff, president of Naroff Economic Advisors Inc. in Holland, Pennsylvania. Firings and shorter hours reduced labor costs by the most in nine years in the second quarter, increasing productivity at the fastest pace in six years, according to government data.

It’s unlikely the combined sales of companies in the S&P 500 will rise as much as analysts estimate when U.S. consumer demand and corporate investment are shrinking, Naroff said.

“Consumers may be on an extended spending holiday and a lot more cautious in their use of credit,” said Naroff, the top forecaster last year in a survey by Bloomberg Markets magazine. “The recovery is going to be slower, and businesses had cut expenses very, very rapidly. Making big profit gains from here, which might seem logical coming out of a recession, is going to be extremely difficult.”

Earnings, GDP

Based on the historical relationship of earnings and GDP compiled by Bloomberg since 1949, the U.S. economy would have to expand by 4.1 percent for profit among S&P 500 companies to match analysts’ prediction for a 25 percent gain in earnings.

The last time S&P 500 profit growth was more than 10 times GDP was in 2002, when earnings climbed 19 percent as the economy expanded 1.8 percent following a recession spurred by the bursting of the Internet bubble. The S&P 500 slid 23 percent that year.

The only other year in which earnings grew more than 10 times the economic expansion was 1993. The S&P 500 added 7.1 percent.

The most optimistic forecast in a Bloomberg survey of 53 economists taken from Aug. 5 to Aug. 11 was for a gain of 4 percent, by Michael Darda of MKM Partners LP in Greenwich, Connecticut. The lowest was London-based First Global economist Nikhil Gupta’s call for a 0.5 percent expansion.

Post-War Record

Firings boosted the U.S. unemployment rate to 9.7 percent last month, the highest in 26 years. That brought the number of Americans thrown out of work since the recession began in December 2007 to 6.9 million people, the most in any post-World War II contraction, data compiled by Bloomberg show.

Increasing joblessness means investors are relying too much on government spending to drive growth in corporate earnings, said Howard Silverblatt, S&P’s senior index analyst in New York.

“We don’t see a whole lot of believers that the economy is getting better or the rally is for real,” said Fred Dickson, who manages $17 billion as chief market strategist at D.A. Davidson in Lake Oswego, Oregon. Investors “are taking a glass- half-empty rather than glass-half-full approach to the world. They’re very, very nervous.”