Third quarter earnings have been repeating the pattern we’ve seen for most of 2013 to date – largely missing revenue expectations and achieving or slightly beating per-share profit forecasts. Looking at the statistics for 3Q13, the results look impressive – 70 percent of companies beat EPS expectations and 40 percent beat revenue estimates. However, it must be noted that estimates were reduced by 6 percent from the beginning of July through the end of the quarter, allowing for an easy beat. Looking more closely at the quality of earnings, most of the year-over-year gains are not coming via increases in operating profit, but from lower tax rates, reduced interest expense and/or lower share counts. This reflects sluggish growth in the U.S. and around the world.
Our forecast for S&P 500 earnings at the beginning of 2013 was $105, about a 4 percent increase from 2012. Our base case forecast, which we believed had a 60 percent chance of coming to fruition, assumed that the economy would continue improving very slowly, home prices would remain more or less flat and that bank lending would increase by 5 percent. The fair value on this scenario, using a 15x earnings multiple was 1525. Our best case scenario called for faster economic expansion, boosted by home prices increasing by 7 percent or more for the year. There would be some sort of deal where European debt issues were kicked down the road to 2014 or later, and there likely would be a “Grand Bargain” reached by the parties in Washington, DC. Our fair market value in this scenario was 1725. The S&P 500 is today at 1765.
Although consensus S&P 500 earnings have eroded through the year, from around $111 to just above $107 today, we believe that given the lowered guidance for 4Q13, the year is going to end with the S&P earnings equaling our $105 number. Going back to our two scenarios above, it’s clear that economic reality has come closer to the base case, but the stock market reacted as if the best case occurred. Why has the market reacted so positively in light of tepid economic conditions? We think the difference is the nearly $1 trillion in quantitative easing by the U.S. Federal Reserve in 2013. This has pushed up the multiple of earnings that investors are willing to pay. The S&P 500 is now trading at about 16.5x 2013 earnings estimates, up from 13 at the beginning of the year.
Make sure to revisit Ramparts for our continued earnings coverage and our year-end forecast.