The weakness of the U.S. stock market over the past week reflects investor uncertainty over how to process each new chapter in Europe’s debt crisis. Contagion is a big worry, and some even mention the USA as a possible domino given its big debt load. The more immediate concern, though, is a collapsing euro, a risk driven home again on Monday as the European currency dipped below 1.23 against the dollar. The accelerated slide in the euro could affect US companies’ earnings prospects in several ways—by making U.S. goods less competitive, reducing the dollar value of euro-denominated profits and, if Europe should go into recession, dampening U.S. sales to the region. David Bianco, the chief strategist at Merrill Lynch, ran some sensitivity tests on corporate earnings to see how vulnerable S&P 500 profits might be to both euro weakness and possible twists and turns in the economy. Given what’s going on in the currency markets right now, its results are worth noting.
Bianco starts out with the consensus view that 2011 earnings for the S&P 500 will run between $85 and $95. The S&P 500 index doesn’t actually earn this amount; it’s a composite that reflects earnings of the S&P 500 companies. Under the “base case” scenario, which Bianco defines as “Core Europe remains healthy but currency is weak,” the U.S. enjoys moderate growth and Asia remains healthy. The bottom line in the base case: The S&P earns about $88. By the way, this scenario also assumes the Euro averages about 1.23 and that oil stays in a broad range of $75 to $90 per barrel.
A slightly worse scenario has the euro dropping to parity with the dollar and also a mild European recession, which is self contained. Under this scenario, which has the U.S. enjoying moderate growth and China seeing healthy growth, oil’s range falls to $60 to $70 per barrel and the S&P 500 earns just $78—not catastrophic but enough of a slip to keep investors timid.
Finally, there’s the a “worst case” scenario, where the Euro falls to parity, Europe’s economy slumps and so does the U.S. (as in a double-dip recession.) Under these dark lights China’s economy weakens too, and oil falls to $60 to $70. The S&P 500’s earnings in this bummer-all-around scenario could fall to $65. By the way, while we’re are still far from this dire outcome know that oil dipped below $70 per barrel in Monday’s trading.
Bianco’s stress tests offer nine scenarios in all, including a “best case” where Europe surprises on the upside, the U.S. charges ahead, oil hangs high at $75 and even the euro holds together, averaging 1.30. Under that heaven-can-wait scenario the S&P 500 earns 100 bucks.
What do these different earnings scenarios suggest about the stock market’s valuation and prospects? One insight, Bianco notes, is that downgrades to U.S. and Asia growth, as well as weak oil prices, pose a far greater threat to S&P 500 profits than a contained European crisis. As for stock market valuation, here’s a quick take using Monday’s market: With the S&P 500 trading around 1125, the market sells at 12.8 times Bianco’s base case (i.e., pretty good) earnings scenario, and 14.42 times the contained-slump scenario. That compares favorably to the long-term average forward P/E of the stock market of 15. Of course, if the worst case scenario unfolds, then the S&P 500 looks expensive even at today’s discounted prices, selling at 17.7 times 2011 earnings.
Admittedly, this feels more like three-dimensional chess than stock market valuation, which could explain why investors are anxious and confused these days.