Many investors have been surprised by the steady advances in the
since it bottomed out three years ago.
They shouldn't have been. History predicted it would happen.
Exiting a major economic slowdown, companies cut costs fairly
quickly, leading to a tremendous spike in
margins. Consider this statistic: Companies in the S&P 500
boosted per-share profits by 38% in 2010, with roughly 80% of that
gains. Sales growth accounted for the remainder.
The margin gains posted by companies moderated in 2011, but were
still good enough for the S&P 500's profits to rise by 16% on
an aggregated basis. Yet in the just-completed fourth quarter, an
ominous sign appeared: profit margins fell slightly from a year
earlier, for the first time since early 2009.
Looking ahead, this should be "the new normal." Year-over-year
profit margins are expected to fall slightly in the first three
quarters of 2012 and rise only modestly in the fourth quarter. The
clear takeaway: to boost profits, companies are increasingly
relying on good old-fashioned sales growth. The good news: a
moderate rise in the U.S. gross domestic product should do
the trick for a number of stocks such as banks, retailers and
late-cycle industrial plays. The bad news: companies that see
minimal sales growth may actually see profits slip back as labor
and material expenses rise higher.
Analysts at UBS figure S&P 500 profits will likely rise roughly
5% this year. And thanks to a move up toward 3%
growth in 2013, profits could rise a more robust 9% in 2013. This
pales in comparison to the gains seen in 2010 and 2011, but is
probably good enough to keep the market from slumping badly. They
also predict the S&P 500 will end the year at 1,475, roughly 5%
ahead of current levels. (Most
firms have raised their S&P 500 price targets since
I looked at their forecasts last month
, but still see little further upside from current levels.
You'll occasionally come across market prognosticators that predict
that the stock market will surge much higher in coming quarters,
and a few have tossed off "Dow 20,000" predictions to garner some
buzz. I think UBS and the other firms are closer to the mark.
They missed this rally with their year-end prognostications, but
with the market's price to
(P/E) (14.6) now higher than its projected earnings growth rate
(12.2%), further euphoria may be capped. That said, a drop in oil
prices and an expected eventual pullback in the dollar could be a
plus for corporate profits. As analysts at UBS note, "risks to our
revenue and [earnings-per-share]
estimates are weighted to the upside."
Even if profit targets for the S&P 500 come in as expected,
many individual stocks can rise appreciably higher -- it's just
important you stay cognizant of the macro picture spelled out above
regarding profit margins. It's crucial that you assume some margin
slippage in your own earnings assumptions, and you'll need to gut
check your sales growth assumptions as well. Europe remains
challenged, so any S&P 500 companies with major European
exposure could disappoint on the earnings front this year.
Roughly 90 companies in the S&P 500 are expected to boost sales
at least 10% in 2013, according to
. And roughly two-thirds of those companies -- or 12% of the
S&P 500 -- should be able to do so again in 2014. Notably,
almost all of those companies are also expected to boost EPS by at
least 10% in 2013 and again in 2014.
But what if we tighten the noose, looking for companies that should
see sustained sales and profit growth of at least 15% in 2013 and
2014? The group falls to just 15 stocks, representing 3% of the
There are some great growth stocks on this list, but it doesn'tmean
investors will (or should) shun value stocks. Indeed, a number of
genuine bargains still exist in the S&P 500, if you are willing
to tolerate decent but not robust sales and profit growth. I went
back and looked at the 90 companies that should see 10% sales and
profit gains in each of the next few years, and found a 15 of them
selling for less than 15 times projected 2013 profits.
make both lists, implying they hold appeal for both growth and
Of course, many other variables will be in play as the market
digests sales and profit trends in the coming quarters. For
example, natural gas firm
Chesapeake Energy (NYSE:
will need to shore up its
if it is to fund its capital spending plans for 2012 that
expected growth in 2013. Conversely, if natural gas prices manage
to start rebounding, Chesapeake,
Noble Energy (NYSE:
Pioneer Natural Resources (NYSE:
and many other stocks could see huge share price
in the years ahead.
You'll note auto parts supplier
in the group above. Many suppliers and auto makers -- including my
favorite auto play --
Ford Motor (NYSE:
increasingly appear poised to exceed consensus sales forecasts, as
monthly sales trends now imply a faster-growing U.S. auto industry.
of Ford in my
$100,000 Real Money Portfolio
.) Whether profit growth can follow suit will be a function of
controlled expenses and a stabilized Europe.
Risks to Consider:
is expected to grow nearly 3% in 2012 and again in 2013. There are
still enough headwinds in place to lead economists to lower their
views, including a deepening slump in Europe -- our biggest trade
partner -- and the negative effects of tax cut expirations expected
at the end of this year. A spike in oil prices could also quickly
derail the U.S. economy as consumers retrench anew.
Action to Take -->
After stunning multi-year gains, it's time to lower expectations
for the stock market. Focus on stocks that have moderate upside
with considerable downside protection. It's exactly the kind of
focus I take in my
, and I wouldn't do it if I didn't think it was the absolute best
way to approach the market right now. The "swing for the fences"
approach may no longer be advisable now that profit margin
pressures change the dynamic of corporate profits.
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-- David Sterman
David Sterman does not personally hold positions in any
securities mentioned in this article. StreetAuthority LLC owns
shares of GOOG, CHK, F in one or more if its "real money"