The Congressional Budget Office yesterday put out some interesting forecasts for the current fiscal year. Corporate tax revenues will come in at $315bn, versus prior forecast of $351bn, it said, and that U.S. real GDP growth will be 1.5 percent, down from previous projection of 3.1 percent! The shocking nature of the new GDP forecast aside, even more important perhaps are implications, if any, for the markets. The bull market (in stocks) is in its sixth year, with persistent increase in valuation multiples. In 2011, the S&P 500 Index traded at 14.5x reported earnings ($86.95), followed by 16.5x ($86.51) in 2012 and 18.5x ($100.20) in 2013. This year, reported earnings are forecast to grow 10 percent to $110.20. If earnings come through, the index (2000.12) currently trades at 18.2x. Importantly, 2014 earnings growth expectations were much higher at the beginning of the year, so they have been progressively revised lower. Now we have the new CBO forecast. There is a tight relationship between growth in GDP and corporate revenue. The latter of course gets translated into earnings. Sure, corporations have actively made use of financial shenanigans (stock buybacks, and what not) to boost the bottom line, but at the end of the day it is the top line that matters. The whole time, investors have been hoping for revenue pickup.
S&P 500 earnings grew 2.7 percent in 1Q14 and 9.9 percent in 2Q14. In 2H, they are expected to grow 19 percent in 3Q14 and 8.4 percent in 4Q14. One primary reason why 2H expectations are so lofty is that the sell-side has modeled in a sharp recovery in the GDP. The CBO now thinks otherwise, and in all probability they will be proven right. There are some indications of continued firmness in the jobs market for at least the next several months and maybe a new lease of life – however shortened — in corporate capital spending, but deep down the recovery is sub-par, with housing now struggling. In this environment, it is not difficult to assume that the expected $110.20 may not be realized this year. Earnings grew 6.3 percent in 1H, to $52.20, and are expected to grow 13.5 percent in 2H, to $58. If we assume that 2H growth rate matches that of 1H, then we are looking at $54.33, not $58, and 2014 total of $106.53, not $110.20. The P/E multiple expands to 18.8x. And get this. Earnings expectations for 2015 currently stand at $132.30!!! The point is, these are lofty expectations and will probably not get fulfilled, let alone in a macro scenario now laid out by the CBO. Probably why the bond market has been diverging from stocks since 2012, and particularly this year. Bond vigilantes apparently do not trust the sell-side forecast. If they did, Treasuries along the long end of the curve would be trading a lot lower.
