Earnings into focus

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As the US Q4 earnings reporting season kicks off, not only growth will be closely monitored but also the quality of earnings. These aspects will be very strongly on my radar screen over the next few weeks as I believe the intermediate trend of the stock market could take its cue from the state of corporate America.

This brings me to the topic of valuations (at 06:00 in the morning in the transit area of Munich airport!). Based on operating earnings (i.e. stripping out everything that is bad), the historical price/earnings (PE) multiple of the S&P 500 is 21.10; using “as reported” (GAAP) earnings the figure is a higher 25.7, but down from the 80+ valuations that characterized the previous few quarters. Getting past the loss-making fourth quarter of 2008 and calculating prospective multiples through December 31, 2010 reduce the valuations to 15.3 and 25.2 respectively – still hardly the type of valuations that will inspire one to be a buyer across the board. (The earnings estimates are courtesy of Standard & Poor’s.)

Another way of looking at valuation levels, and cutting through the uncertainty of having to forecast earnings, is by means of Robert Shiller‘s cyclically adjusted price-earnings ratio (CAPE), effectively muting the impact of the business cycle by averaging ten years of earnings. Using rolling ten-year reported earnings, my research (based on Shiller’s methodology, but including some refinements) shows the “normalized” price-earnings ratio of the S&P 500 Index is currently 21.2. This compares with a long-term average of 16.4 and implies an overvaluation of 29.3%. The graph below show data since 1950, but the actual calculations date back to 1871.

sp150110

Albert Andrews, strategist of Société Générale, provides an interesting graph showing the run-up in the US forward PE has not been accompanied by higher expectations of long-term earnings growth. “This means the equity market is far more reliant on the expectations for strong 2010 growth being fulfilled, said Andrews.

sp150110-b

Source: Société Générale – Global Strategy Weekly, January 11, 2010.

I repeat my conclusion of Sunday’s “Words” from the Wise” review: “It goes without saying that the strong rally since March is bound to be followed by a correction at some stage. But rather than pre-empting (and more often than not getting it wrong as a result of short-term noise), I will be guided by the longer-term charts and the yield curve to identify a major top. Meanwhile, I am watching valuations carefully, and specifically how the Q4 earnings reports stack up. Although I am treading with caution after the 75% rally in the mature markets and 109% in emerging markets, I am not ignoring good old stock picking, and specifically those companies with strong balance sheets that will be growing their dividends over time with a reasonable degree of certainty.”

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2 comments to Earnings into focus

  • Frank W

    The information contained in this article is perplexing. Look at the first graph. That big base is a very good looking Elliott wave base for what I call a “bull flat”. A bull flat is a very strong rally. I would expect an upward curving “C”-wave to form, which would top
    around maybe the 80 level. Such an outcome is not inevitable. It is possible for this expected rally to short circuit, but usually they follow thru. Now Prieur computes the 1 year P/E ratio including the forward estimate for 4Q09 and gets around 15. This is what the market sees as about average and therefore is buyable at that figure. How does one rationalize the conflicting analyses? Well, try this on! In the 12 months to November, M3 or broad money grew only a little over 1%. This is only an estimate by John Williams at the Shadow Fed. The Real Fed quit computing M3 in 2002, when M3 was growing out of control, because it is the best estimate of money supply and they don’t want us to know what’s really going on. They regard us as the proverbial mushroom patch. Since November, M3 has CONTRACTED 5%. MZM or current money is also contracting. The velocity of M3 is also falling. Q or one measure of GNP = M(3) x V. Therefore, GNP — it seems to me — should already be in the process of contracting. One should pay close attention to the forthcoming earnings reports. Alcoa, which is regarded as a bellweather, posted a disastrous report to put it mildly. On the other hand, Intel’s report was nothing short of brilliant. However, one must keep in mind that tech does not pace the rest of the market well. Keep watching those earnings reports and especially those for the 1Q10. Albert Edwards, whom I have referred to as Edward Albert in the past for some inexplicable reason, evidently doesn’t see much future earnings growth either. This man is well regarded.

  • [...] I do not have much to add to my conclusion of last week and repeat it: It goes without saying that the strong rally since March is bound to be followed by a correction at some stage. But rather than pre-empting (and more often than not getting it wrong as a result of short-term noise), I will be guided by the longer-term charts and the yield curve to identify a major top. Meanwhile, I am watching valuations carefully, and specifically how the Q4 earnings reports stack up. (See my post “Earnings into focus“.) [...]

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