Sent: 17-04-2012 13:40:02
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Earnings, Valuation and Monetary Stimulus
As the quarterly US earnings parade kicks off this week attention will begin to focus on which is more important for share prices: earnings growth, valuation or monetary stimulus.
In the June quarter of 2000, US S&P 500 earnings peaked at an annualised rate of $59.52 a share after the index had finished the March quarter at a peak of 1498.6.
In June 2007, earnings peaked 62% higher than in 2000 but the S&P 500 share price index finished June within just five points of its June 2000 level.
In the September quarter of 2011, S&P 500 earnings had recovered fully from the losses made in 2008 but, when the results were reported in October, the index was 20% lower than at the end of October 2007.
These three contradictory views of the connection between earnings and valuation have left investors without any clear-cut benchmark against which to judge the appropriate level of the market at the present time.
The market approaches a new earnings season this week launched, as usual, with the release of results from Alcoa. As a group, analysts are forecasting earnings to grow by 20% over the course of 2012. That would be consistent with an improving US economy, including more supportive consumer demand as employment growth strengthens and optimism builds.
In some contrast to this optimism, the consensus among the stock analysts is for March quarter earnings to be unchanged from those in the December quarter which were themselves 6% lower than a quarter earlier.
As analysts have been grappling with the nature of the US economic recovery, they are depending more than ever on companies to guide their estimates. As a result, initially optimistic forecasts based on strategists' expectations of a building recovery have been wound back as the reporting period comes closer and companies guide expectations lower.
The currently expected $23.73 earnings for the S&P 500 companies in the March quarter have been cut back by 7% over the past three quarters. The tendency for negative revisions leaves more than the usual doubts about the forecast for the rest of the year.
This picture of continuing earnings uncertainty wrapped in a reluctance to look ahead more than a few months does not sound an attractive environment for equity markets generally.
This picture runs counter to the optimism in the market during the first quarter and the historical tendency, discussed in the ATC e-mail last week, for the first quarter market outcome to set the tone for the full year.
Current expectations about first quarter earnings imply a trailing four quarter price/earnings ratio of 14.4. If earnings remained at that level throughout 2012, they would be running at the peak levels of 2007 and the four quarter trailing price/earnings ratio would be 14.8 compared to 16.4 in June 2007.
The market is applying a heavier discount rate to earnings than it did in the two cycles that finished in 2000 and 2007. Based on historical pricing, it seems to be foreseeing a more significant deterioration in earnings outcomes than has occurred so far.
Over the next few weeks, followers of the US market will also be listening closely to the US Federal Reserve governors as they grapple publicly with the possibility of giving the US economy more monetary stimulus to bring it closer to their targeted growth path. Several are scheduled to speak publicly this week alone.
The current program of swapping long dated securities for shorter term government paper - tagged "Operation Twist" - is due to finish in June. Fed governors have been talking about a further round of quantitative easing - "QE3" - but, as a group, have been unconvinced about this course for two reasons.
Firstly, there have been signs of a sustained economic expansion already having commenced. Secondly, many economists expect further monetary easing to have diminishing, if not negligible, benefits.
Embracing QE3 would flag Fed doubts about the sustainability of recovery. At the same time, quantitative easing acts through its effect on asset prices and most directly benefits equity prices, even if it has no other beneficial effect. Weaker earnings combined with QE3 could result in stronger equity markets.
Lower earnings than currently forecast appear likely. That alone may not force markets lower because a significant fall in earnings is already embed in equity prices.
Over the next few weeks, a clearer understanding of the direction of US equity prices should emerge as resolution of the three-way battle between earnings, valuation and monetary stimulus gets closer.
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