Will Earnings Eventually Support the Stock Market Rally?

Since closing at 676.53 on March 9th, 2009, the S&P has rallied some 63.7% to its current level of ~1108. Some market pundits attribute this meteoric rise to the Fed's unprecedented market intervention(s), which has created massive amounts of liquidity. Other skeptics call it another round of irrational exuberance; a short-lived bull market within a cyclical (or secular?) bear market. Still others say this rally is for real, that the equity markets typically look 6-9 months into the future, and that only the fools are still on the sidelines.

Granted, stocks have become relatively non-cheap, at least in terms of the multiples of reported earnings which they're trading. The real question behind this debate however, is "Whether corporate earnings will catch up to, and eventually support, the current stock market's trading range". Before I attempt to answer that question, I'd like to first frame the argument in terms of the psychological basis from which each side is attempting to further its argument.

The first point I need to make is that this economy IS recovering. However, the rising tide is not lifting all boats. I wouldn't want to be D.R Horton right now, but I wouldn't mind being Intel. Most of all, I would not want to be a small business; they have effectively been denied access to nearly all sources of credit, they aren't large enough to throw their weight around with suppliers, and oh yea, health insurance premiums are about to go up. Given this set of facts, its easy to see why nearly every small business owner in this country is quite pessimistic at this moment. Furthermore, small businesses don't use - or even understand for that matter - GAAP accounting. Their focus is on cash in v. cash out, i.e small business income statements are usually just two lines: sales and costs. Therefore, profit boosting concepts like LIFO liquidations and unrealized gains on trading securities are somewhat foreign, effectively obfuscating their perception of recent corporate profit increases. Psychologically, they are mad; the government bailed out big business and didn't throw them a crumb. Watching the stock market rise on a daily basis simply angers many small business owners.

On the flip side, big business reacted quickly and viciously to the Great Recession; they laid people off in the thousands and shuttered profitable plants/mills just to achieve higher asset utilization rates. The result was the temporary occurrence of costly restructuring charges. The largest of these are probably behind us though, meaning that bottom lines will be juiced in the coming quarters. The next advantage available to big business is global scale; there may be little US based sales growth in the months ahead, but developing markets continue to grow. Given this set of facts, many large corporations that operate in a handful of industries have reason to be cautiously optimistic.

Don't think for a minute that the current stock market bulls v bears argument isn't completely driven by this psychological and economic dichotomy. Bulls typically cite the earnings cycle, proposing that the following sequence of events will lead to an earnings - and an economic - rebound:

1. Corporation's cut costs
2. Productivity Increases
3. Profits begin to increase
4. Inventories are replenished
5. Capital Expenditures are made
6. Hiring resumes
7. Consumption rebounds

In contrast, the bears are either in denial that corporate profits will increase, or (the more sophisticated ones) would say that once inventories are replenished, firms will hold onto cash and the capital expenditures will never materialize. From my perspective, the resumption of hiring looks to be the major impediment to a recovery. When hiring does resume, it will be at the largest, healthiest multi-national corporations. Furthermore, those hired first will the most educated and most able to add value to the firm. Housing and construction may never return to pre-recession employment (absolute) numbers, and manufacturing jobs will continue to be lost to a combination of technology and China. This doesn't bode well for the consumer as a whole, whom I expect to behave anemically for another 3-7 years.

That all being said, the answer to the title to of this post is something to the effect of "some of them". It's up to individual investors to figure out which firms have the global scale and management capacity to go out and find (take?) new sources of revenue, whether it be via acquisitions or expansion into new markets. Beware of dead business models.  Sphere: Related Content

The Stock Market: Expensive or Not?

The attractiveness of the stock market, from the perspective of an individual investor, is largely based upon the determination as to whether or not stocks are "cheaply" valued. Unfortunately however, it can be difficult for the average individual to properly assess current market valuations. First of all, stocks do not adhere to the everyday concept which tells us lower prices are synonymous with cheapness. This misunderstanding has been prominently displayed by many of our acquaintances who have proudly announced the purchase of a stock(usually in a social setting, usually drinking is involved)  based upon the assumption that it is cheap. These folks have made decisions based upon a perceived cheapness, relative to some price anchor that they have established for the stock in question. For example, a stock that traded in the $30 range only two years ago, and is now but a $5 stock, will be purchased on the assumption that it will inevitably return to $30. Secondly, there are numerous valuation metrics from which to choose from, most of which provide seemingly contradictory signals. For instance, a stock might look cheap based upon the ratio of price to as-reported, undiluted earnings, but appear expensive when subjected to a discounted cash flow analysis. Obviously, there is plenty of gray area in all of this.

As far as this current equity market is concerned, we have been told repeatedly that stocks are "in the bargain bin". We will now look to the available data for the S&P500 index and attempt, in an impartial and straighforward manner, to either verify or refute that claim.

Index-wide earnings for the S&P500 are reported in the two separate ways below:
Operating Earnings- Income from the sale of goods and services
As-Reported Earnings- Income from continuing operations as defined by Generally Accepted Accounting Principles (GAAP)

Our earnings figure of choice will be "As-Reported Earnings". This decision stems from a couple of grievances we have with the "Operating Earnings" figure. First of all, we are wary of the fact that these numbers are not standardized according to GAAP. While standardized accounting principles are not perfect, we ardently prefer a slightly flawed yet standardized measure over the inconsistency that is inherent to earnings designations made outside of the GAAP framework. Most suspect, we believe, is the fact that Operating Earnings exclude what is known as "unusual items". Essentially, a company has characterized a particular charge to earnings as "unusual" and thus can pretend that it did not really happen. Unfortunately, the world is defined by events and occurrences that would be largely considered unusual. Unusual things happen, and they matter. That being said, we will still provide the data for both earnings figures if for no other reason than to appease those who suffer from chronic delusions. Below are the quarterly, aggregate earnings per share for the S&P500, as reported by Standard and Poors:

Operating Earnings As Reported Earnings

Q1 2009 $10.07                  $7.57

Q4 2008 -$0.09                   -$23.25

Q3 2008 $15.96                   $9.73

Q2 2008 $17.02                    $12.86

At the time of this writing, the S&P500 index stands at 883.24. Given the current annualized index-wide earnings rate of $40.28(Operating) and $30.28(As Reported), the S&P500 is trading at earnings multiples of 21.92 or 29.16, depending on your method of earnings calculation. Furthermore, since 1988, the index has traded at an average P/E of 19.27 and 23.16 respectively. Typically, the index has overshot its valuation average, to the upside during the final stages of economic expansion, and to the downside during economic contractions, recessions, depressions or whatever your title of choice may be. When assessing this all in the entirety, we must conclude that the S&P500 is currently somewhat expensive. Granted, the market is anticipating a bounce in earnings over the next several quarters. Should this happen, now would be, in hindsight, a great buying opportunity. However, we would strongly caution individual investors against wading into the current market, unless however, you are extremely comfortable and familiar with the use of option contracts as risk management tools. That is but all the wisdom we currently have to offer.

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