Meet the Street: A Bear Among Bulls

As corporate America closes the books on 2001 earnings, Wall Street is widely forecasting a better chapter in 2002.

But not everyone is so optimistic: Tom Van Leuven, U.S. equity market strategist at J.P. Morgan Chase, isn't predicting any earnings growth this year, and he thinks analysts are too optimistic about their vision for technology profits. In 2002, Van Leuven estimates the S&P 500 will fall nearly 20%.

Last year, Van Leuven and his J.P. Morgan team were closer than most other strategists in their forecast for the S&P 500, predicting the index would end up at about 1400, while others said it could reach 1675.

Only time will tell what happens this year. In the meantime, here are Van Leuven's thoughts.

TSC: Analysts are currently forecasting that S&P 500 earnings will grow 16% in 2002, according to Thomson Financial/First Call. Do you think that's realistic?

Van Leuven: That's a very optimistic forecast. We estimate earnings growth for 2002 will be 0 percent. In our view, the first half of 2002 could look similar to the second half of 2001, and the second half of 2002 could be roughly equivalent to the first half of 2001. We'll be on an upward trajectory as the year progresses, but we're not going to get to a level that's significantly above that of 2001.

TSC: What do you think about current forecasts for technology earnings in '02?

Van Leuven: The consensus is very optimistic on technology. For the S&P tech sector, the consensus is predicting 46% earnings growth -- the highest in the market on a sector basis. That's not likely to be the case. The problem for technology is earnings are very tightly connected to capital spending budgets.

Thomas Van Leuven, Strategist, J.P. Morgan Chase

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Capital spending may not be going up a whole lot this year, for a couple reasons. One, there isn't a big need for new investments, with capacity utilization in U.S. running so low. Why make a lot of new investments when you're not using everything you've got? Two, we're not convinced that companies could make big investments, even if they wanted to, because the earnings picture isn't terrific, corporate cash flows aren't great and leverage in corporate America is relatively high.

TSC: Have most sectors already discounted an earnings recovery this year?

Van Leuven: There aren't many that haven't priced in a recovery. Energy would be one sector where a rebound isn't factored into prices already. Earnings growth for the energy sector is expected to be down 25% this year, which is in striking contrast to other cyclical sectors like tech.

But among the other groups, basic materials is expected to have 43% earnings growth, capital goods is forecast to have 13% earnings growth and consumer cyclicals is predicted to have 20% growth. If there is an economic recovery, there will be some adjustment upward to energy earnings growth forecasts. If there isn't one, or it's disappointing, that could lead to downgrades of cyclical sectors' growth estimates.

TSC: With the kind of earnings growth that you expect, how much can the S&P 500 tack on in 2002?

Van Leuven: We think the S&P is going to fall almost 20% from current levels this year. Our target is 950 for the S&P in '02, based on expected earnings relative to the consensus. Also, we're starting out at pricey levels relative to the market's price to earnings, both forward and trailing, and to bond yields. It will be tough to see an upward price move on the S&P, starting out at such a rich valuation.

TSC: How do you come up with your model?

Van Leuven: We look at earnings yield relative to bond yields to make a judgment about overall market valuations. Investors have the choice of financial assets -- with bonds the main alternative to equities. And when one becomes expensive vs. the other, there is less demand for it.

Where you start out is an important thing to know. We don't assume we're starting out at fair value. Instead, we think we'll get there through changes in earnings, bond yields or relative prices. This year, we don't expect significant changes in earnings or bond yields, but we do expect changes in relative prices. That will have the effect of taking stock prices down relative to bond prices.

The Fed model assumes the fair price-to-earnings multiple for the market on 12-month forward earnings is the inverse of the bond yield. The current bond yield -- 5% -- says a P/E of 20 is appropriate for the market. With the S&P at 1165, the Fed model tells us we need S&P earnings of $58 to justify current prices. That would be a record year -- $56 was the level in 2000.

We don't think we're going to get anything close to record earnings this year.

TSC: After the Enron (ENE Quote) collapse, what should investors be looking for in individual earnings reports?

Van Leuven: We don't rip through financial statements, like industry analysts. But the lessons of Enron are, basically, know what you're investing in. That's a pretty straightforward message.