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Trust Record-High Earnings, Not Depression-Level Consumer Sentiment


Consumers might not be happy, but earnings and relative valuations argue for higher stock prices.

How much will you pay for a $95 annual income stream?

That's the question investors should be asking themselves. Despite all of the macro hysteria in recent months, the actual cash flows provided by stocks have been pretty steady, as the chart above from Goldman Sachs shows. We're still on pace for $95 to $97 in S&P 500 earnings per share this year, roughly the same estimate range people had back in January. As of the third quarter, S&P 500 trailing 12-month earnings will be the highest on record.

It sure doesn't feel that way, does it?

As the chart above from Calculated Risk shows, consumer sentiment remains near multi-decade lows. What's going on?

Not to turn this into another Occupy Wall Street jeremiad, but we've seen a steady shift toward economic gains collected by corporations at the expense of labor, as the chart below shows (hat tip to my friend Matt Busigin for the chart).

Since 2000, corporate profits' share of GDP has risen from roughly 5% to roughly 10%. Meanwhile, over that same time frame, labor's share, represented by wages and salaries as a percentage of GDP, has fallen from 49% to 44%. In a $15 trillion economy, that 5% share transfer means that, in a way, $750 billion per year has been transferred from workers to corporations' bottom lines. That's around $5,800 for each of the nation's 130 million nonfarm employees, or, using an average wage of around $50,000, would pay for another 15 million jobs.

So it's no wonder that consumers are depressed. But just because people are depressed doesn't mean that the earnings streams of corporations are in jeopardy. Companies ranging from Microsoft (MSFT), IBM (IBM), and Intel (INTC) to Target (TGT), McDonald's (MCD), and Walmart (WMT) are growing revenues, earnings, buying back stock, and paying higher and higher dividends.

This year we have seen economic chaos in Europe, mild austerity in the US, a debt ceiling scare, and the country's credit rating downgraded. Yet corporate America continues to chug along, and indeed, third-quarter GDP printed at 2.5%, its highest level in over a year. Within that GDP release, private fixed investment contributed 1.6%, its second-highest contribution since at least 2008. If fixed investment is going to add 1% a quarter, there is more or less no mathematical way to have another recession.

I'm not going to claim things are great out there. Much of the country remains in a severe recession or worse, regardless of what the aggregated statistics say. The MF Global (MF) saga shows an alarming lack of reform of our financial system. Europe remains on the brink, and for all we know Greece is hours away from tipping over the first domino in the Armageddon scenario people have been fearing for over a year. But if I had to handicap things, I'd say there's a 90 to 95% chance the US continues to limp along in a 1 to 2% GDP world with corporations continuing to grind out modestly higher earnings.

Which leads us back to the original question. What will you pay for a $95 income stream? My favorite way of looking at this is using the equity risk premium (ERP), the difference between the earnings yield of the S&P 500 and the 10-year Treasury yield. Since 1962, there have been two instances where the ERP finished the year at 4% (1977 and 1979), and one where it finished at 6% (1974). Every other year it has finished below 4%. Last year it finished at a relatively high 3.4%. Right now, with the 10-year Treasury yield at 1.99%, the S&P 500 at 1,218, and expected S&P 500 earnings per share (EPS) of $95, the ERP is 5.81% ($95 EPS divided by the cash close of the SPX, 1,218, minus 1.99%).

Macro strategists like to talk about situations being unsustainable -- an ERP of 5.81% is unsustainable. Some combination of higher Treasury yields, higher equity prices, and lower earnings is going to occur.

If you think the 10-year yield will rise to 2.5%, the $95 EPS target will hold, and an ERP of 4.5% is reasonable for this environment, that implies an S&P 500 level of 1,360. This seems somewhat conservative.

Unless Europe really does fall into a black hole, stocks, especially quality stocks, will dust themselves off and keep heading higher. It might not make consumers any happier, but that's the likely path.


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