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Digg
During the rally off the March 2009 lows, the quarterly check-in on earnings sometimes proved a downer — albeit a temporary one — from the seemingly unstoppable rise in stocks.
Take the flurry of reports on the third quarter of 2009 for instance, which began with Alcoa’s report in early October. Check out the dip we saw:
Similarly, stocks staged a pit stop during the reports on the fourth quarter of 2009. They were released from the middle of January until the end of February. (Just FYI, we’re taking Target earnings as the semi-official end of the bulk of earnings season. There is no official end.)
Most recently the first-quarter 2010 results that came in early April seemed to presage the spate of weakness we’re still mired in. So why are we getting somewhat optimistic for the start of second-quarter earnings?
Well, first we take it for a given that most companies will top the consensus expectations of Wall Street, thanks to the long-standing experience among executives at managing analyst optimism. So, what’s most important is not whether the companies actually clear the bar, rather how the market is set up going into earnings season.
On that count, it seems that stocks could be coiled and looking for a reason to spring higher. We’re still down some 7.6% from the April 23 peak for the S&P. But the worries about Europe seem to have faded in volume. China feels confident enough in its economic growth to start to appreciate the yuan. And most importantly it seems that stateside equity analysts have been getting a little bit more realistic about the outlook for profits, and trimming back their revisions.
Back at the beginning of May analysts were pricing in $20.16 of second-quarter earnings for the S&P 500. By the start of June that was $19.77. As of Tuesday, that figure was $19.65, according to numbers from Thomson Reuters.
It might seem counterintuitive, but the fact that analysts are getting a little bit more realistic about their earnings expectations looks like a positive sign to us, since the inability of stocks to rally last quarter through earnings season suggested that the optimism about profits had gotten out in front of the ability of corporations to actually monetize economic conditions.
In short, it seems that the market is less sure stocks are going to get out of this correction any time soon. And in that respect it sort of reminds us of the earnings season back in July 2009, when there was widespread skepticism about whether the rally off the March lows could keep going higher. Lo and behold, earnings came through better than Wall Street expected, and the market legged up, see:
We’re thinking, we may be in for a similar situation next month. Although we reserve the right to revisit this if we get a surge in stocks ahead of earnings, say, from the June jobs report (July 2), or ISM numbers (July 6).
Think we’re wrong? Fire back in the comments section, state your case.
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It’s not about equity analysts getting real, it’s about the market getting real. Currently the S&P500 is at the level of 2004 when the current economic conditions of federal debt, employment and housing have nothing in common with 2004. Markets do not have to be linked to economic realities, but those realities eventually will come back to haunt the market. Consumption is 70% of GDP. Companies can be sitting on a bundle of cash; it’s not going to do them any good without the economy in an upward trajectory.
I believe you are referencing operating earnings and not actual as-reported earnings. As we should have learned from recent experience, all bad economic events are deemed extraordinary by management and excluded from operating earnings. So, in reality, earnings are more like $15-$16 for the second quarter instead of $19-$20. Since operating earnings are structurally higher than actual earnings, they should be ignored.
It’s not all about dividend, priceless. In reality, price goes up when demand goes up, provided the supply remains relatively constant. What makes demand go up? Many things, and the expectation of future cash flows isn’t the only one, but it is the one that existing theory deals with the most. What does a company do with it’s cash? If it has projects that it believes will yield a return that exceeds the cost of capital, then it does that, instead of offering a dividend, and the investor benefits from a rising share price as the company’s ability to generate cash goes up. We call this a “growth” stock. If it doesn’t have any new projects that it believes will bring a return that is at least as high as the cost of capital, then it should simply return the cash to investors in the form of a dividend, because the shareholder can invest that cash for himself and potentially get a better return in the market than the company can create internally. We call this an “income” stock. Of course, dividend policy is more complicated than just this alone.
Of course this is all just theory. Over the short term, there can be a sharp disconnect between cash flow and share price. A rising tide lifts all boats. As the investment horizon gets longer, you expect to see cash flows and share price correlations become tighter.
Because of short-term volatility, appreciation of share price based on P/E ratios can have a speculative aspect to it, depending on your horizon. But on the other hand, dividends aren’t a sure thing either. (BP, for example.) I’m not sure exactly what strategy Warren Buffett used to make his first million, but since then he has done well for himself by investing in high quality cash flows when he can get them for a bargain, which, to be fair, is a little more than is suggested by a straight P/E ratio, but it’s all a part of the larger, consistent, investment theory.
Why should P/E ratios matter at al? If the company makes money (actually profit is not even equal to cash in the accural based accounting), why should an investor pay a higher price for the stock? What is in it for him/her? Until the management shares the profit with the owners (read dividend..), there is no ROI for the investor. Any appreciation of stock price based on P/E ratio is just speculative. However, the market does not care at all for dividend yield at least for now.
Stocks always have a reason to go up. Good earning = higher stock prices. Bad earnings = everybody is no negative that stocks have nowhere to go but only go up. Either way, stocks will always go up. What happened in 2008 was an anomaly.
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