Stocks have staged a big comeback, rising more than 100% from the darkest days of the financial crisis exactly three years ago. But is this rally justified by the companies’ fundamentals or is this just a speculative bubble that is setting us up for another big fall? Looking at corporate earnings and valuations–rather than the soaring stock prices–can give us a sense of how companies are really doing. Fourth quarter earnings season (when companies report results for the last quarter and for the full year of 2011) are just finishing up. How did things look?
First the good news. With the earnings season now ending, the results generally came in better than expected and earnings of the companies in the S&P 500 grew on average 5.64% and sales 5.53% when compared with the fourth quarter of 2010. This was the ninth consecutive quarter of earnings growth as companies have bounced back strongly from the depths of the Great Recession in 2009. Of the S&P 500 companies, 65% reported earnings above the average estimate issued by the big Wall Street banks and brokerage firms. Apple (AAPL), Intuitive Surgical (ISRG), Intel (INTC) and McDonalds (MCD) all announced earnings and sales higher than analysts expected and higher than the previous year, just to name a few standouts in our clients portfolios.
Now for the not-so-good news. While earnings have been increasing over the last several quarters, they have been doing so at a decreasing rate. The 5.53% average earnings growth of the S&P 500 was a sharp slowdown from the third quarter of 2011 growth of 14.89%. The 65% of companies that beat estimates sounds impressive, but actually this is below the average percentage of companies that beat estimates.
To make matters worse, if you take out the two biggest contributors to this quarter’s earnings, AIG and Apple, earnings growth for S&P 500 companies slows from nearly 6% to 1.2%. Apple reported earnings more than double the previous year’s, and the troubled insurance giant AIG benefited from weak comparisons from the year before.
What is the cause of this mediocre earnings season? Part of this slowdown of growth is simply the result of tougher comparisons. In the first quarter of 2011 when earnings grew more than 50%, the numbers were being compared to the recession lows of 2009. Now we are looking at the fourth quarter of 2010 for comparison, when the economy was well out of recession. But in addition to tougher comparisons, companies are now facing a deeply troubled economic environment in Europe and a slowdown in the rapid growth of developing countries in addition to the lackluster domestic economy. In numerous earnings reports this quarter we read about the effect of higher costs, weak demand in Europe and slowing emerging markets. Looking ahead to this quarter, if these trends continue we could very well have a decline in total earnings for the first quarter of 2012.
But what is remarkable is how well companies have fared in this difficult environment. We also saw in this quarter’s earnings reports extremely high profit margins, record cash holdings and increasing dividends. Companies are in good shape even with earnings slowing down. Historical valuations are also low, given the long rally. The Price-to-earnings ratio based on forward earnings of the S&P 500 is at 12.5 compared to a historical average P/E of 14.6. By comparison the market P/E during the internet bubble of the late 1990’s reached as high as 40. While there is always the possibility of a market correction after a long rally, the current valuation suggests that stocks could still have some room to run.
The weakening earnings trends means that earnings growth is less likely now to fuel a continued rally in the near-term, but there could be other things that push stocks upwards, like more signs of an improving US jobs or housing market, or a partial resolution of the European debt crisis. This week the positive results from the Fed’s recent round of stress tests of big banks drove the market up. What’s really striking about the current market is how so many investors, scarred by the financial crisis, are remaining on the sidelines. As more people take note of the tremendous rally and become dissatisfied with record low yields of bonds, they may start to put their money back into stocks and mutual funds and ETFs and push the market higher.