Risks to the overall Market (from Rosenberg):
1. Double-dip risks have been averted
We disagree with this new-found consensus view. People don’t see that the principal driver of economic growth in Q3 was a 30%-plus annualized surge in auto production (related to the GM IPO). This alone added 1½-percentage points to current quarter growth — for an economy that likely expanded at a 1-2% rate, which means that pretty well all, if not most, of the GDP gains were situated in automotive assemblies. The fact that ISM new orders and backlogs fell so sharply in September, together with the 5% slide in August automotive shipments, is a tell-tale sign that this contribution to GDP growth will reverse course in the fourth quarter, when indeed, odds of a renewed contraction in GDP are nontrivial.
Moreover, from our lens, after netting out the massive inventory contribution to headline GDP growth in the last year, we have real final sales growth running at a mere 0.8% annual rate. Assuming that the inventory rebuild process has hit its peak, and that we do end up seeing 1.7 percentage points of fiscal restraint (in terms of GDP impact) for 2011 (under status quo fiscal policy), then arithmetically the economy will end up contracting 0.9% next year barring a major offsetting positive aggregate shock to domestic spending.
2. A muddle-through economy will generate $95 of earnings next year
Indeed, this is the bottom-up S&P 500 operating EPS estimate that is currently driving equity valuations — if you don’t believe it, then go to page 26 of Barron’s (Facing Up to the Real Third Quarter). That would be a 14% gain on top of this year’s anticipated 36% bounce. But here’s the problem, the economy is no longer accelerating, it is decelerating. And to show how a sub-2% real GDP growth can wreak havoc with corporate earnings when margins are close to peaks rather than troughs, the national accounts data show vividly that on a sequential seasonally-adjusted basis, pre-tax corporate earnings (without IVA and CCA) barely rose at all in Q2 (+0.9% QoQ). So continued double-digit YoY growth (the consensus is +24% for Q3) is masking the slowdown evident on a quarter-by-quarter basis.
$95 of earnings next year on the S&P 500 — this is the bottom-up estimate that is currently driving equity valuations
Here’s the rub: to get that $95 operating EPS for 2011, we either need to see at least 7% nominal GDP growth, which last happened in 1989 when inflation was 5%, not close to zero, or margins manage to reach new all-time highs. We won't entirely rule this out, but will give it 1-in-25 odds of occurring. All we can say is that the base case is for low single-digit nominal growth and some margin compression so frankly we could be looking at something closer to a $75 earnings stream next year. Moreover, when one slaps on a 10x multiple on that — consistent with the economic uncertainty commensurate with a post-bubble deleveraging cycle — then getting to 750 at some point in the S&P 500 is not at all out of the question.
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