Are Positive Earnings Already Priced In?

Discussion in 'Economics' started by S2007S, Jan 19, 2010.

  1. S2007S


    A very nice detailed article, with the markets up over 70% from March lows you have to actually take into consideration that earnings really have to outshine and continue to outshine for many quarters to come. Most of these earnings will beat this quarter due to low estimates from analysts and plenty of cost cuts from nearly every company in the s$p.

    Are Positive Earnings Already Priced In?

    By Simon Maierhofer , On Tuesday January 19, 2010, 12:47 pm EST

    Have you ever heard the saying, 'Buy the rumor and sell the news?'

    This seven-word phrase may never have been more apropos than today. Yes, never is a strong word to use, but when was the last time that earnings announcement were preceded by a 70% rally without note-able correction?

    If there was a perfect time for positive earnings to be baked into prices already, now would be the time.

    According to analysts polled by Barron's and Bloomberg, combined earnings for the S&P 500 companies are expected to jump 23% to $73.69 a share next year from $59.82 in 2009. As the chart below shows, even rising earnings per share (EPS) do not guarantee a rising market.

    Some analysts, like JP Morgan's Lee, predict that S&P 500 profits will clock in at $80 a share.

    Earnings reports - a double edged sword

    Earnings estimates are by no means guaranteed. In fact, analysts reserve and exercise the right to modify their estimates at a whim. In March 2009, as the Dow (NYSEArca: DIA - News) was approaching 7,000, Goldman Sachs and many others went on record forecasting falling estimates.

    On March 9th, 2009, the very day the major indexes a la Dow Jones (DJI: ^DJI), S&P 500 (SNP: ^GSPC) and Nasdaq (Nasdaq: ^IXIC) bottomed, the Wall Street Journal reported that Goldman Sachs had revised their previous forecast of $64 a share to $40 share.

    At the same time, Goldman's chief strategist Kostin presented three possible future scenarios. Scenario 1 put the S&P 500 at 400 - 500. Scenario 2 placed the S&P between 650 - 750 and scenario 3 pegged the S&P to 940. Believe it or not, all three predictions failed.

    Contrary to Wall Street's wisdom, the ETF Profit Strategy Newsletter issued a buy signal via the March 2nd Trend Change Alert. The Trend Change Alert recommended to close out previously recommended short ETFs and start buying long and leveraged long ETFs, such as the Vanguard Financials ETF (NYSEArca: VFH - News), Direxion Daily Financial Bull 3x Shares (NYSEArca: FAS - News), and many others.

    The top of this rally was predicted to occur somewhere close to Dow 10,000 at a time when optimism is rampant and 'the worst is over feeling' sets in.

    Is the light at the end of the tunnel for real?

    After being stuck in a tunnel, any light is welcomed. Could the light many see at the end of the economic tunnel be another train? The overwhelming consent is certainly that the worst is over, the light is for real. Optimism has reached levels not seen in years, even decades. How can optimism be measured?

    Investors Intelligence tracks the recommendation of different market advisors. As of the most recent poll, 53.4% of all advisors are bullish. 30.7% of advisors are longer term bullish, but believe a short-term correction is likely. All together, 84.1% of advisors are bullish. Even the October 2007 market highs did not elicit such a positive response.

    How about retail investors? According to the American Association of Individual Investors (AAII), investors are only keeping 18% of their money in cash. This is the lowest level since April 2000.

    It is important to connect the dots when talking about investor sentiment. The last extreme reading of market advisors occurred on October 15th, 2007, within less than a week of the all-time market top. Thereafter, the broad stock market fell (NYSEArca: VTI - News) 55%. Certain sectors like financials (NYSEArca: XLF - News) and real estate (NYSEArca: IYR - News) tumbled 70% and more.

    The last time investors felt comfortable enough to keep only 18% of their money in safe cash was in the very early stages of the tech-crash. Within a year, the Technology Select Sector SPDRs (NYSEArca: XLK - News) and Nasdaq (Nasdaq: QQQQ - News) had lost more than half of their money.

    No doubt, the optimism surrounding this year's earnings announcement is decisively bearish. In the past, when earnings season was greeted by extreme optimism, the S&P 500 was 2 - 3 times more likely to go down than up. The maximum performance to the downside trumped the upside by more than 2x.

    A quick summary

    So far we've seen major earnings reports by Alcoa, Intel, JP Morgan, Citigroup and some others. Alcoa disappointed, Intel impressed. Although Citigroup beat the Street's estimate of 33 cents a share loss in the quarter, shares fell 3% in early trading today.

    Good news and bad news, thus far has resulted in lower prices.

    This type of inconsistency between reports and stock's reaction is more common than many realize. In the past we've seen stellar earnings by troubled financial giants greeted by lower prices while outright disappointments coincided with higher prices.

    A look beyond the obvious

    Alcoa, being one of the multi-national Blue Chip components of the Dow Jones, generally kicks off earnings season. Since much of Alcoa's revenue is received in currencies other than the U.S. dollar, the fourth quarter weakness in the greenback should have added to its bottom line - it didn't.

    In fact, for 2009 Alcoa recorded a negative profit (also considered a loss) of over $1 per share. This makes it tricky to value Alcoa. Further, it is not the only company that didn't make money in 2009.

    The negative profit epidemic has infected many of the S&P 500 companies. In turn, this makes it difficult to value the S&P 500. How much is a company that doesn't make any money worth.

    The Standard and Poor's P/E ratio for the S&P 500, based on actually reported earnings, is 84.30. This means, it would take any S&P constituent an average of 84.3 years to repay the money it borrowed from investors. This does not include interest. How willing would you be to offer a business loan payable over 84.3 years at no interest?

    Of course, the P/E ratio falls if you compare the current price with expected earnings. But as we've learned above, Wall Street has a tendency to go with the flow when it comes to earnings.

    In March, when things looked bad, Wall Street expected things to get worse. Now when things look good (after a 70% rally), Wall Street expects things to get better. 2010 earnings forecasts are 23% higher than what we see right now. This could be a stretch.

    Are higher prices ahead?

    Based on investor sentiment, stocks are due for a correction to say the least. But what does the stock market say?

    Different valuation metrics are the market's built in temperature gauge. When things heat up, the market is forced to cool down - this means lower prices.

    Historically, the market is 'healthy' with a P/E ratio around 15. Based on actual earnings (P/E of 84.3) the market is overvalued by more than five times. Using a more 'conservative' methodology, the S&P 500 on a normalized Shiller P/E basis is overvalued by close to 30%.


    P/E ratios are not the only valuation metric, however. Dividend yields and the Dow measured in real money - gold (NYSEArca: GLD - News) are others.

    If you own dividend ETFs like the SDR Dividend ETF (NYSEArca: SDY - News), or value ETFs with an income component like the Vanguard Value ETF (NYSEArca: VTV - News), you know that dividends are negligible. In fact, dividend yields are close to an all-time low.

    All major market bottoms over the past 100 years had one thing in common. LOW P/E ratios and HIGH dividend yields. What we are witnessing right now, is exactly the opposite. That's not what bull markets are made of.

    A look at the Dow Jones measured in gold shows just how overvalued stocks denominated in U.S. dollars (aka Dow Jones) are. Indicative of their implications, we've dubbed the composite indicators consisting of P/E ratios, dividend yields, the Gold-Dow, and mutual fund cash levels as the 'Four Horsemen.'

    The ETF Profit Strategy Newsletter contains details of the 'Four Horsemen,' plotting stock market prices and each indicator individually against historic market bottoms, along with a short, mid and long-term forecast that includes the target range for the ultimate market bottom.