Earnings Will Shape Debate

10/17/2011


Stocks have rebounded into earnings-reporting season, helped by hopes for a European bank bailout and some better-than-expected U.S. economic data. Near-term trading will hinge on earnings news, and subscribers should be looking for opportunities on a stock-by-stock basis. But, with the primary trend in the bearish camp, we're holding about one-fourth of our buy lists in a short-term bond fund as a partial hedge.

Earnings surge

Since year-end 1998 total operating earnings for the S&P 500 Index have more than doubled, yet the index's price is down 1%. As a result, the index trades at roughly one-half the trailing price/earnings ratio of 13 years ago, at the low end of a 50-year range.

Has the P/E been halved because the recent earnings surge — with seven consecutive quarters of year-to-year growth exceeding 15% — is unsustainable and set to reverse given the headwinds facing the global economy? Or have investors become so disgusted with the stock market that the impressive results of corporate America are not being recognized?

Those questions will not be answered definitively over the next month, but the market's reaction to September-quarter results will shape the debate. Heading into earnings season, the September-quarter numbers appear solid, with the consensus projecting year-to-year earnings growth for all 10 S&P 500 sectors except utilities.

Overall S&P 500 Index earnings are expected to be up 13.3% — down from the 17% that was expected on July 1 but above the 12.6% expected at the beginning of 2011. The number of profit warnings has been only slightly worse than historical norms, and quarterly earnings will reach an all-time high if companies surpass expectations by a typical amount.

As always — and especially today given the gloom surrounding the economy — investors will be most interested in guidance for the December quarter and 2012. December-quarter expectations have been trimmed only modestly over the past three months, with the consensus projecting 15% year-to-year earnings growth for the S&P 500 Index. For 2012, the consensus calls for 13% growth.

Conclusion

While consensus forecasts appear optimistic, today's modest valuations suggest investors are not counting on 13% profit growth next year. Subscribers should hold some extra cash on the sidelines while looking for attractively valued growers with operating momentum. Top picks include Apple ($400; AAPL), DirecTV ($46; DTV), and Intel ($23; INTC).


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