Last week, I shared a range of expectations for what I thought the S&P 500 could do in 2010 if the index generated earnings growth of a certain level. The response I received from a few readers boiled down to why I was questioning whether the S&P 500 could generate that level of growth, particularly coming out of a recession. The logic goes that, to use the basketball terminology, it should be a slam-dunk.
While I can understand the shoot-from-the-hip logic, drilling down a bit reveals that expectations for earnings-per-share growth of more than 27 percent in 2010 over 2009 is more likely overly optimistic than not.
Keep in mind that the $74.25 forecast by the Street is a consensus number, and as such, there are some forecasting higher results, as well as those predicting a lower earnings number.
But as I pointed out last week, in the past 49 years of data for the S&P 500, year-on-year earnings growth has been greater than 20 percent only seven times and only twice (1976 and 1984) after a year in which those earnings declined. S&P 500 earnings are expected to fall 11 percent in 2009, following a drop of 23 percent in 2008.
Putting aside what others are estimating, let's think about what the earnings of the S&P 500 really are and what that means in everyday terms. To calculate its earnings per share, one has to aggregate the earnings of the 500 companies in the entire portfolio. But rather than simply accepting earnings forecasts, let's consider what we see going on in the world, a reality check of sorts. After all, when we boil it down, these forecasts are more or less opinions, and it always pays to ponder opinions or ourselves.
To begin with, a company's earnings reflect revenue and costs - so to increase our earnings, all things being equal, a company needs to grow its revenues in excess of its costs. Costs reflect all sorts of inputs - materials, energy costs, labor, benefits and the like.
Basic materials and commodities have posted meaningful increase year on year, and those will start to affect a company's cost structure when they need to replace less-expensive materials inventory as it is consumed. Energy costs are measurably higher than year-ago levels. Employee-benefit costs will be rising, given pending health care changes as well as rising unemployment taxes and other taxes.
Also, odds are the cost to borrow will rise in 2010, should the economy pick up steam and the Federal Reserve need to hold inflation in check. And should the global economy accelerate faster than most expect, these cost inputs will increase faster than currently thought.
Given the current unemployment picture, which is not expected to reverse in the near term, a rise in those costs will constrict consumer spending as well, and thus pressure the domestic economy.
From the historical perspective to what the near-term economic outlook is, it seems to me that 27 percent earnings growth for the S&P 500 in 2010 is aggressive. I continue to think we will see positive earnings in 2010, but not to that degree. I hope that many will see this and revise downward those forecasts. Look out if they do not.
•Chris Versace is director of research at Think 20/20 LLC, an independent research and corporate access firm based in Reston, Va. He can be reached at cversace@washington times.com. At the time of publication, Mr. Versace had no positions in companies mentioned. However, positions can change.