S&P earnings head south

Most equity bull runs are about rising valuation multiples. Japan peaked at 60 times trailing earnings in late 1989 and the technology-crazed US market at 31 times in early 2000. This time round it is different. The price/earnings multiple of the US, at 18 times, has actually been declining for several years. Stocks may have soared, but earnings have risen by more, to levels which imply unsustainably high returns on capital. Bears worry about a profit bubble, not a valuation one.

That makes the third-quarter US earnings season, which will be largely completed by the end of this week, worrying. Taking a blend of actual and estimated earnings, S&P 500 profits will drop by 1 per cent year- on-year, according to Thomson Financial. This is the first fall in 19 quarters, and represents a slump in expectations. In July, third-quarter growth was forecast to be 6 per cent.

Subprime related write-offs by financials have hit the numbers. Excluding financials, earnings growth would be 5 per cent. But the urge to remove “one-offs” should work both ways. The weak dollar, down 5 per cent on a trade-weighted basis year- on-year, probably boosted growth by 1-2 percentage points. And there is a big debate about how “one-off” the drag from financials is, given their profits are at a cyclical peak and contribute a third of the S&P total.

The US national accounts also suggest that profits have stalled, with growth rates in low single digits in the first half of 2007, versus the mid-teens in 2006. This data series captures US-based activity – not the global profits of US-listed companies – but as Smithers & Co points out, there is a fair correlation between it and stock market earnings.

In the face of a profits brick wall, investors have, in order of sanity, bought emerging market equities, bid up companies with high overseas exposure and resurrected the dodgy gospel that Federal Reserve cuts can override the profit cycle. The seven earnings slumps since 1947 have all hit fast (an average of 31 months from peak to trough profits) and hard (cutting a third or so from profits). When corporate profits fall there is no easy escape.