Thoughts on earnings

Where is the stock market headed, or maybe a better question is what should the S&P 500 be trading at? Generally the level is closely related to earnings and as earnings for the 500 have dropped since last year so has the market valuation. However, we are now in earnings season and as companies make announcements, the S&P is going to react.

There are a number of historical charts on the relationship between the S&P level and earnings. Generally the price/earnings ratio needs to provide a yield that is better than what you can get in US Treasuries since realistically, why take a risk if you are going to get less money than you would for not taking a risk? Right now this would require returns of at least 5% but that isn't enough of a premium so generally I think 7-8% is a better gauge. At 7.5% you would trade at 13.3 times earnings. Generally $55 is the current estimate for 2009 so the S&P lower limit would be in the 730 range. Now if you are will to accept the 5% return with the hope of future growth, the P/E ratio changes to 20 and we get an S&P at 1100. A more normal P/E ratio tends to be about 17 so a reasonable estimate is 935.

Now of course the estimate for earnings and whether it should be earnings from operations or GAAP earnings, (includes all accounting write-offs and additions) is the starting point. I prefer earnings from operations, since if you start using gains and losses from asset valuations, and other accounting requirements, you add a lot of individual company variability. I think those things are important is assessing the long term well being of individual companies, but distort the overall comparisons too much. As an aside, all those asset write-offs due to property and inventory valuations, may now actually be hidden assets if the valuations have any upside.

However at a P/E of 17 the return is around 6% (5.88) and it is fairly safe to say that the market want to get at least the treasury rate of about 4% plus protection against inflation. So if you expect inflation to be 1% we are back to a P/E of 20, at 2% 17, at 3% 14 etc.

So level of earning with return on treasuries and inflation expectations can give you a good estimate of where the S&P should be.

Concerning earnings, while revenue is down for most of the S&P companies we have seen aggressive cost cutting and inventory reductions (look at unemployment and commodities). This is likely to show some earning improvement despite the fact that the level of activity is reduced. Two things should be considered. I think companies need to adjust to a reduce level of consumer spending. This doesn't mean they can't be profitable, simply that they need to be profitable at a lower level of sales.

Growth will return, but barring an unexpected surge in real estate prices, consumers simply don't have the ability to spend like they used to. We also know that ugly reality has hit the baby boomer generation and that the comfortable retirement they envisioned from the equity in their homes and the gains in the stock market have vanished. They are now saving more and spending less. I don't expect this to change. However, if GM for example can be profitable selling 2 million cars a year, is it a bad investment? It won't be as big as it once was, nor will it employ as many people, but it may still be a good investment.

So I expect that we will continue to see earnings beat expectations because of the cost reductions, not revenue growth. In fact I believe what we saw from Alcoa may not be far from the norm, where the aggressive cost cutting allowed them to beat expectations, admittedly still losing money, by 30%.

It may seem a bit contradictory, but the cyclical industries hardest hit by the recession have had the best opportunity to do drastic cost cutting.

How will the Market react? Initial reaction to the Alcoa earnings is positive. I would think that as earning continue to beat estimates we will see the S&P go to the 935 level and possibly approach 1000. However, the naysayers will talk about a sluggish recovery with little job growth and reduced consumer spending. True enough, but if we accept that the economy isn't going to return to 2007 levels, have we recalibrated sufficiently to grow from where we are?