Next Hurdle For Market: Earnings Season

1/3/2011


Stocks finished 2010 on a high note, with both the Dow Industrials and Dow Transports reaching fresh 28-month highs in December. The Dow Theory is squarely in the bullish camp. But stocks are no longer especially cheap, so news related to December-quarter and 2011 profits will be crucial in the near term. For now, we're holding 15.9% to 17.3% of our buy lists in a short-term bond fund.

Earnings outlook

Writers of stock-market commentary are always on safe ground stressing the importance of corporate profits. But after a 21-month market advance and impressive run of strong earnings, the outlook for profit growth seems especially crucial, for at least four reasons:

• Stocks are no longer cheap. Among the small, midcap, and large stocks in the S&P 1500 Index, the median trailing price/earnings ratio is nearly 19 — above the norm of 18 since the S&P 1500's 1994 inception. The median stock also trades at a slight premium to long-term norms based on price/cash flow and enterprise ratio. Enterprise ratio equals enterprise value (the value of debt and equity, less cash) divided by EBITDA (earnings before interest, taxes, depreciation, and amortization).

• Interest rates have stopped falling. Stocks remain attractively valued relative to bond yields. But flat or higher rates in 2011 would mean stocks have lost an important tailwind, making earnings growth even more central to the bullish case for stocks.

• Investors, accustomed to strong growth, may be harder to satisfy in 2011. According to analysts at Deutsche Bank, U.S. corporate profits have risen at a 33% annual rate since bottoming in the final quarter of 2008 — the fastest growth over seven quarters on record. Consensus estimates project 31.9% year-to-year growth for S&P 500 Index profits in the December quarter, but growth is expected to slow to 13.4% for 2011.

• Investors have been rotating into shares of rapid growers. Among the six category scores used in our Quadrix rating system, Momentum has been the most effective since mid-September. In fact, the top 10% of S&P 1500 stocks based on Momentum scores, which reflect recent growth rates, have outperformed the average S&P 1500 stock by more than 7% since Sept. 15. In contrast, top Value scorers have lagged since mid-September, suggesting investors are placing increased emphasis on operating momentum.

Revision trends for the December quarter have been mostly favorable, and we expect another quarter of better-than-consensus earnings when earnings season begins in the second and third weeks of January. But investors will be on high alert for any signal that expectations for 2011 are too optimistic. For new buying, subscribers should emphasize profit growers with attractive valuations, including Apple ($325; AAPL) and Ameriprise Financial ($58; AMP).


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