On Wall Street

October 14, 2011 6:25 pm

Investors must ask how good the good news is

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Wall Street’s cheerleading on profits requires careful thinking

The third-quarter earnings season for US companies arrives at a juncture when stocks are rebounding strongly from their recent foray into bear market territory.

Since an inauspicious start to the month, the S&P has rallied more than 11 per cent with the index back over 1,200, while on Friday the Dow Jones Industrial Average and Nasdaq Composite moved back into positive territory for the year.

Recent US economic data suggest fears of deteriorating growth might be misplaced, while investors are hopeful that European policymakers are finally going to deal with their long-running debt crisis and the capital issues gnawing at the region’s banks.

As companies have started releasing their latest results, the rally in equities still leaves the market looking cheap when compared with the lofty earnings expectations of Wall Street analysts.

This comes as analysts have been scaling back their third-quarter estimates, with growth currently seen at 12.6 per cent, down from 16.94 per cent since mid-July according to S&P Capital IQ.

But that outcome would still mark an eighth successive quarter of double-digit growth for profits and Wall Street is confident that the good times will roll into 2012.

Over the next 12 months, analysts expect S&P earnings of $106.49 per share according to FactSet. That translates into a 12-month forward price to earnings ratio of 11.3 times, well below the 10-year average of 14.9 times, which suggests equities are undervalued.

Record profit performance from US companies over the coming year should result in the S&P trading closer to 1,500, rather than its current level of 1,220.

Certainly, one cannot rule out a big year-end rally if the US economy shows greater signs of life and European policymakers find a silver bullet for their debt crisis.

As we have seen before, notably in March 2009 and last November with the launch of the Federal Reserve’s Quantitative Easing policy, or QE2, despair over equities can quickly shift to euphoria with the potential to ignite a powerful upswing in the market. These kinds of rallies ultimately suck in cash from sidelined investors and can gain formidable traction.

Any clarity over the macro outlook would enable investors to focus more closely on the profits outlook and maybe start believing the earnings hype that is emanating from Wall Street.

The more likely scenario is that Europe still faces a messy resolution of its debt troubles and the US economy muddles along at a tepid pace, hampered by the long process of deleveraging in the wake of the burst housing and credit bubble.

A relief rally in stocks over the US averting a recession is one thing, but what really matters is the kind of recovery that eventuates. For now, economists are not talking about blockbuster growth in 2012.

And this is where the 12-month earnings expectations may run into trouble and puncture the bullish view of analysts.

As it stands, US corporate profits as a percentage of the total economy are running at record levels, stretching back to 1929. Such elevated profit margins suggest there is not a lot of room left for companies to keep squeezing costs. Lacklustre growth, particularly with emerging market economies currently slowing down, means that margins can only starting compressing.

Beyond a likely return of profit margins to their much lower long-term average, another reason to think stocks are overvalued and not a bargain resides in viewing the S&P through the lens of Professor Robert Shiller’s cyclically adjusted price earnings, or Cape, ratio.

This measure divides the S&P by the 10-year average of inflation-adjusted earnings so as to smooth out the volatility of profits over a business cycle. The Shiller P/E suggests the market is overvalued by about a third at its present level.

So for all the cheer the current earnings results may bring, investors have sound reasons to think carefully about Wall Street’s cheerleading on profits over the forthcoming year. Ultimately, margins will compress and then investors will discover whether 1,220 on the S&P is a bargain or not.

michael.mackenzie@ft.com

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