Our metals and consumer teams have recently warned of the pitfalls of seemingly attractive forward valuations in their sectors, arguing that current levels might ignore the potential for consensus earnings downgrades. Below are MSCI Russia sector indices’ 12M forward P/Es today and their estimated values if consensus forward EPS on 1 July 2011 (i.e. before the start of downgrades) was slashed by 50% of the EPS reductions seen from the 2008 peak to the 2009 trough.
Although probably too pessimistic, we find that materials currently look the most overvalued in the event of sharp earnings cuts. Telecoms and utilities appear at much less risk than other sectors. Consensus EPS for financials, which is not included as it would show a negative P/E, has declined just 2% since 1 July, while over 2008-09 the market’s earnings outlook turned negative.
While the market’s aggregate forward EPS is up 3% since 1 July (vs -59% in 2008/09), this results entirely from upgrades in the energy sector. In light of risks to the oil price from slowing economic growth globally, we see a threat of downgrades to the energy sector’s earnings, with implications for the overall market’s earnings and valuations. Furthermore, given that EPS upgrades in 1H11 probably assumed that global growth would not slow, existing earnings estimates may look stretched. We also caution against viewing the high EPS outlook as positive for the stock market as forward EPS tends to be a lagging indicator.
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