By Lynn Thomasson and Michael Tsang
Oct. 5 (Bloomberg) -- Wall Street projections for the fastest U.S. profit growth in two decades are putting some of the biggest equity investors at odds with Bill Gross.
Money managers are betting that more than two years of declining earnings, the longest stretch since the Great Depression, will end in 2010 when net income rises 26 percent before expanding 22 percent in 2011, according to data compiled by Bloomberg. Gross, who oversees the world’s biggest bond fund at Pacific Investment Management Co., says the economy won’t grow fast enough to sustain the steepest rally since the 1930s and equity returns will be limited to 5 percent a year.
While investors drove the Standard & Poor’s 500 Index up 52 percent since March anticipating a U.S. recovery from the first global recession since World War II, the gauge fell 1.8 percent last week as the unemployment rate rose to the highest level since 1983. Even though 3,800 analyst estimates in a Bloomberg survey show profits will rebound next year, their average predictions indicate companies will start reporting a ninth quarter of declining earnings this week.
“I reject this notion of a 5 percent return and ‘new normal,’” said Fritz Meyer, the Denver-based senior market strategist of Invesco Aim, which oversees $149 billion. “I wouldn’t be surprised if the rate of recovery is even better.”
Futures, Quarterly Rallies
Futures on the S&P 500 added 0.3 percent at 8:43 a.m. in London today amid speculation that a report from the Institute for Supply Management will show service industries in the U.S. stabilized last month.
The S&P 500 posted the steepest back-to-back quarterly gains since 1975 in the past six months as the U.S. government and Federal Reserve lent, spent or guaranteed $11.6 trillion to revive the economy. Profit gains will push combined S&P 500 earnings above $92 a share within two years, an all-time high, according to the estimates compiled by Bloomberg.
Economic reports last week told a different story as the Labor Department said unemployment rose to 9.8 percent, the Tempe, Arizona-based Institute for Supply Management’s factory gauge showed that manufacturing expanded less than economists estimated and the New York-based Conference Board said that consumer confidence unexpectedly fell.
Analysts’ forecasts sound “excessively optimistic,” Gross, the co-chief investment officer at Newport Beach, California-based Pimco, said in an Oct. 1 interview. “It’s very rosy and very Goldilocks and unlike the scenario that we see, which is a ‘new normal’ with very slow growth rates.”
Alcoa, GE
Alcoa Inc. is scheduled to release third-quarter results on Oct. 7, the first among Dow Jones Industrial Average companies. Fairfield, Connecticut-based General Electric Co. and Intel Corp. of Santa Clara, California, are also among the 45 S&P 500 companies that will report in the next two weeks.
Analysts surveyed by Bloomberg estimate that operating income at S&P 500 companies dropped 23 percent in the July-to- September period. The two-year streak of profit declines for U.S. companies would continue in the year’s final three months if not for a 132 percent gain in earnings at financial firms, according to forecasts compiled by Bloomberg.
Bulls say equities are cheap because estimates show profits will surge 54 percent the next two years, the steepest increase since 64 percent from 1986 to 1988. That’s faster than the 46 percent expansion predicted for companies in the Shanghai Composite Index, even though economists forecast China’s economy will grow three times as much as the U.S. in 2010.
Inexpensive Market
The S&P 500 traded for 20.2 times the reported operating income of its companies last month, the most since 2004. Using estimated 2011 earnings drives the valuation down to 11.1, or only 10 percent higher than the 24-year low based on trailing results reached in March.
“The market is inexpensive,” said Mary Chris Gay, a fund manager at Baltimore-based Legg Mason Inc., which oversees $693 billion. “It would not be unreasonable to expect the market to be up 25 to 30 percent over the next year.”
Demand from China, the world’s biggest consumer of metals and second-largest buyer of oil, may help push earnings at U.S. commodity producers 149 percent higher over the next two years, the steepest increase among the S&P 500’s 10 industries, excluding financials, the estimates show.
Profits at New York-based Alcoa, the largest U.S. aluminum company, will rebound to 88 cents a share in 2011 after an 83- cent loss this year, according to the average analyst estimates. Irving, Texas-based Exxon Mobil Corp., the biggest U.S. oil company, is projected to almost double earnings in two years.
‘Maybe Even Surprise’
“It’s quite possible that next year’s earnings could reach levels that are expected and maybe even surprise to the upside,” said Linda Duessel, who helps manage $402 billion as equity-market strategist at Federated Investors Inc. in Pittsburgh. “The market is becoming more used to the idea that we are in a recovery.”
The profit growth forecast by analysts for 2010 is 11 times faster than the expansion in GDP projected by economists surveyed last month, the highest ratio on record, based on data compiled by Bloomberg going back 60 years.
Gross says his expectation for inflation-adjusted growth of no more than 2 percent isn’t enough to push annual stock returns above 5 percent. His new normal encompasses heightened government regulation and lower consumption as Americans reduce debt.
Total Return
The S&P 500 increased 11 percent on average in the five years ended in 2007, before falling 38 percent last year. The index posted the biggest annual decline since 1937 as the collapse of subprime mortgages spurred $1.6 trillion in writedowns and credit losses at financial companies globally and sent the U.S., Europe and Japan into the first simultaneous recessions since World War II.
During the last two bull markets, the S&P 500 had an average total return of 18.6 percent a year, according to data compiled by Bloomberg.
Since 1970, U.S. government bonds have returned 4.6 percent annually after adjusting for inflation, according to Chicago- based Ibbotson Associates Inc. data compiled by the London Business School and Credit Suisse Group AG in Zurich.
“The fact is that stocks are up almost 50 percent from the bottom and so if we’re talking about stock prices, as opposed to corporate profits, it would be fair to say a lot of that’s already in the market,” Gross said. “The V shape stands very little chance of being realized, either from profits or stock prices.”
Post-Recession Growth
Fritz Reynolds, who oversees the Reynolds Blue Chip Growth Fund in Maui, Hawaii, says the economic revival will be too slow to support analysts’ profit projections.
The U.S. economy will expand 2.4 percent next year, rebounding from the worst contraction since the Great Depression, according to a Bloomberg News survey of economists last month. In the four quarters following the other two recessions since World War II that lasted more than a year -- the 1973 to 1975 and 1981 to 1982 downturns -- growth averaged 6.2 percent and 7.8 percent, respectively, data compiled by Bloomberg show.
Demand from China may not be enough to maintain commodity prices as stockpiles of raw materials rise and shipping rates drop. Oil inventories rose 12 percent in the past year, Energy Department figures show, while the Baltic Dry Index, a barometer for raw-material demand, slid 41 percent in the third quarter.
“Analyst estimates seem pretty high,” said Reynolds, whose $46 million Reynolds Blue Chip fund has outperformed 99 percent of rivals in the past five years. “What makes me cautious is that it was just nine months ago that things were really bad in the economy.”
House Divided
The dilemma that investors face can be seen in the diverging forecasts at JPMorgan Chase & Co., where New York- based chief U.S. strategist Thomas Lee advises clients buy companies most tied to economic growth, while European analysts led by Mislav Matejka say investors should pare holdings.
Lee recommended in a Sept. 18 report that investors buy so- called cyclical stocks over defensive ones because profits are rising and they’re cheaper relative to historical valuations.
Matejka, Lee’s counterpart in Europe, said in an Oct. 1 note that the rally in cyclicals will slow because the stocks are expensive. Energy shares in the Dow Jones Stoxx 600 Index trade for 14.8 times income, compared with an average of 10.4 over the last five years, according to data compiled by Bloomberg.
David Kelly, who helps oversee $474 billion as chief market strategist for JPMorgan Funds in New York, says increasing earnings means stocks remain a buy.
“The uplift in profits should be very dramatic,” said Kelly. “We have embarked upon a recovery. So far, I don’t see any reason for that recovery not to proceed.”
To contact the reporters on this story: Lynn Thomasson in New York at lthomasson@bloomberg.net; Michael Tsang in New York at mtsang1@bloomberg.net.
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