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Are stocks cheap? That depends if you believe the numbers. For particular stocks, they look good; but for the market as a whole, it's not so clear.
Wall Street strategists interviewed for this week's Barron's cover story ("Which Way Up?" ) thought stocks were headed higher. And a cynic might observe that a barber also would probably say you could use haircut. Top clients of Wall Street firms get unvarnished guidance, as with hedge-fund customers of Goldman Sachs who recently were advised on how to profit from the deepening crisis in Europe, as the Wall Street Journal recently reported.
The crux of the mainstream bullish argument for stocks put forth by the marquee-name strategists is that stocks are inexpensive based on standard measures such as price-earnings ratios as well as the equity-risk premium. Both measures depend crucially on corporate earnings forecasts, which are open to uncertainty, however.
The problem with forecasts is that they are about the future, and the future is unknown. Even the recent past is subject to revision, which means what we know ain't necessarily so. And so our expectations are off, which feeds into P/Es and equity-risk premiums.
That thought is prompted by the most recent report from Societe Generale's lead global strategist, Albert Edwards, who is no stranger to readers of this space and Barron's magazine as well. Corporate profit margins were terrific in 2010 but have become less so this year. Labor costs are surging, which is slashing margins. Edwards thinks we are at a tipping point at which companies no longer can pass on cost increases in a low-demand world.
To which I would add that corporations have responded to higher expenses of all types, whether for personnel or materials, by battening down labor costs and whatever else that can be trimmed. Nil jobs growth in August is an example of this effect. It is an example of how QE2 -- the Federal Reserve's purchase of $600 billion of Treasury securities -- has backfired by mainly increasing costs instead of aggregate demand.
In any case, Edwards points out the "remarkable turn for the worse" taken this year by productivity, the ultimate source of our wealth. As a result, unit-labor costs -- a major determinant of corporate earnings and inflation -- have vaulted higher at a faster pace than selling prices.
"This is very bad news for profits. Bad news for equities," he writes. "And because the pace of [unit-labor costs] is a key driver of inflation (upwards in this instance), it is bad news for an increasingly criticized and divided Fed."
Trends in productivity have deteriorated, much more so than thought, given revised data. Edwards notes an initial estimate of first-quarter productivity was revised significantly, to an annualized decline of 0.6% from an increase of 1.8%. As a result, unit-labor costs' increase was revised to a "staggering surge" of 4.8% from 0.7%. In the second quarter, unit-labor costs increased at a 3.3% pace, up from the initial estimate of 2.2%. That puts ULC at a 2% year-on-year rate of increase.
All of which suggests that the extraordinary earnings recovery, based largely on profit-margin expansion instead of top-line growth, is coming to an end. And that has translated to a "near-record decline" in U.S. corporate earnings estimates by analysts over the past six months, Edwards observes.
The Standard & Poor's 500 trades at 13 times the consensus estimate of $90 earnings per share and just 11.5 times the $102 forecast for 2012, according to this week's Barron's cover story. The corollary is that the equity-risk premium -- what investors get paid for the risk of holding stocks -- is near a record. The equity-risk premium is calculated by comparing stocks earnings yield (the inverse of the P/E) to the 10-year Treasury yield, which is what's always assumed to be the so-called risk-free long-term interest rate. With the 10-year Treasury yielding less than 2% and an equity earnings yield over 12%, stocks' prospective returns should vastly exceed those of government bonds.
That may be true for some stocks but not necessarily the entire market. P/E ratios are low only to the extent that the "E" meets forecasts. Rising labor and other costs in excess of top-line gains make it tougher for companies to hit their earnings numbers. Indeed, writes Edwards, a tipping point for profit margins has been reached.
Some stocks already sell at extremely low P/Es of 10 or less despite massive earnings growth over the past 10 years. Another article in this week's Barron's lists 22 S&P 500 companies that have seen their stock prices decline over the past 10 years despite earnings' increasing as much as fivefold over the span.
That has left a group of large, global Blue Chips with rock-solid balance sheets, high dividend yields and significant cash generation potential to expand payouts selling at low valuations, as I wrote last week.
Other stocks will be susceptible to shrinking margins as costs rise faster than revenues. The truism that it's a market of stocks never has been truer.
Comments? E-mail: randall.forsyth@barrons.com
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