Earnings Arrive At Crucial Juncture

10/11/2010


Every earnings season is crucial. The one just under way seems especially important, for at least five reasons:

The averages are trading near significant highs, so a favorable reaction to September-quarter results would be bullish. The Dow Industrials are within 2.5% of their April high of 11,205.03, while the Dow Transports are about 5% from their May high of 4,806.01. A close above those levels would put both averages at two-year highs — and make it hard to see the primary trend as anything but bullish.

Stocks have bounced sharply over the past five weeks, and the market appears overbought on a near-term basis. The percentage of NYSE stocks trading above their 200-day moving average, historically a decent barometer for the risk of a correction, has climbed to a five-month high of 72%.

Sentiment has become much more optimistic over the past five weeks, so companies may find it harder to impress investors. The percentage of bullish investment newsletters has jumped to 46%, up from 29% on Aug. 31 and the highest level since May, according to Investors Intelligence. Investors now widely expect the Federal Reserve to begin buying bonds again in an effort to lower interest rates and juice the economy, as yields on 10-year Treasury bonds have dropped to the lowest level since early 2009.

Estimate-revision trends have worsened recently. Consensus profit estimates for 2011 have dropped since August — the first reductions in more than a year. The ratio of negative-to-positive profit warnings for the September quarter, 2.3-to-1, is slightly above historical norms and up sharply from recent quarters.

Stocks remain cheap relative to bond yields, but comparisons to historical valuation levels are not as compelling. As shown in the chart below, the median stock in the S&P 500 trades at 16 times trailing earnings, below the norm of 18 since 1992.

Valuations are significantly cheaper based on expected year-ahead earnings. But expectations seem optimistic, with forecasts based on estimates for individual companies calling for S&P 500 Index earnings to climb 14% next year to a record $95 a share. Among 11 strategists making top-down forecasts based on broad economic trends, the consensus is just $87 a share, according to Bloomberg.

The median S&P 500 stock trades at a price/sales ratio 10% higher than the norm since 1992, partly because companies have become better at wringing profits from each dollar of sales. With corporate profits near all-time highs as a percentage of national income, many strategists are skeptical that companies will be able to sustain profit growth well in excess of sales growth. The current reporting season should shed some light on this question, as some companies are likely to provide full-year 2010 and 2011 guidance with their third-quarter results.

Conclusion

Earnings news will likely set the market’s near-term direction, and a favorable reaction that lifts the averages to new highs would be a bullish development. For now, we are holding 20% to 30% of equity portfolios in a short-term bond fund.


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