THE BIG PICTURE ARCHIVE
Last Update: 17-Jan-12 09:45 ET
Fundamental Matters -- Earnings and Europe
The focus on corporate earnings the next few weeks is likely to be a positive for the stock market.
Back to Basics
The value of a stock is determined by current and future earnings discounted to a net present value. Thus, earnings and interest rates are ultimately what define stock values. As fourth quarter reports start in earnest this week, the stock market will be and should be focused on earnings. The market is poised to react bullishly.
All Else Is Tangential
The pablum on TV could lead an uninformed investor to conclude that the stock market is some sort of magical barometer as to how "things are going" across the world.
That is, if Europe is having troubles, Middle East tensions are rising, and the U.S. Congress can't get its act together, the stock market should go down. In this view, any time something goes "wrong" in the world, U.S. stocks are less valuable.
That just isn't true.
It is certainly true that geopolitical issues, political issues, and credit market problems in Europe can impact earnings for U.S. companies, and, in that respect, these factors are indeed important.
The extent of the impact, however, is often greatly exaggerated due to fears. The fear factor has been extreme since 2008, when the U.S. credit market implosion sparked a sharp sell-off in stocks.
Of course, that sell-off proved vastly overdone, and the stock market has risen sharply the past three years. Nevertheless, it is the fear that tangential factors will set off a sharp decline in future earnings for U.S. companies that has the stock market massively undervalued on a historical relative basis.
Recently, however, the focus has shifted from European issues back to U.S. corporate earnings. Some commentators have suggested this indicates a "decoupling" of U.S. stocks from European issues. Perhaps.
What is really happening is that the European issues are being kept in proper perspective while the far more important hard-core reality of earnings appropriately takes center stage.
The news will be good.
Wall Street plays an earnings game every quarter. It goes as follows.
Ahead of earnings reports, analysts lower earnings forecasts for individual companies. This reflects caution as analysts hate to overestimate earnings because it makes them look bad to their clients if the stocks they have been covering (supporting) go down.
Also ahead of earnings, companies that are having a difficult quarter will issue warnings and announce that they won't hit Wall Street estimates. Earnings forecasts for companies that otherwise would have "missed" expectations are now reset to exceed expectations.
Some companies also indicate at that time that future earnings may be disappointing relative to Wall Street forecasts. This leads to the frequent talk ahead of earnings reports that "it won't be earnings that are important, it will be the guidance from companies."
This seems entirely reasonable, but usually proves false. The quarters ahead are always more difficult to estimate than the one that has just finished, so analysts are more surprised by companies that warn about their year-ahead outlook than by a company missing current quarter earnings by a bit. Companies that "warn" usually take a severe stock hit.
In the end, however, it is the aggregate earnings trends that impact the overall market.
And there are often few surprises in aggregate.
Every quarter, about 65% of companies will beat Wall Street estimates. About 15% to 20% will miss, and a similar number will come in on estimate to the penny.
Overall earnings growth will be a couple of percentage points (perhaps more) ahead of expectations.
Not every quarter plays out exactly the same, and the degree to which earnings beat estimates and the general tone of guidance for the full year can impact underlying market sentiment.
Nevertheless, it is extremely common for market sentiment to be cautious at the start of earnings season and for market sentiment to improve as earnings seasons progresses and it becomes clear that it was another quarter of earnings "beating expectations."
Expectations for This Quarter
Current forecasts call for the S&P 500 to post earnings growth of 10% in the fourth quarter of 2011 compared to the fourth quarter of 2010.
This would take the total earnings for 2011 to $96.48 per share (adjusted to the S&P 500 in sum). That would put the current P/E on the S&P 500 at 13.3 (1287/$96.48). That equates to an earnings yield (E/P) of 7.50%.
Based on current forecasts of $106.22 for the S&P 500 for 2012, the P/E on year-ahead earnings is just 12.1 while the earnings yield is 8.25%.
These valuations represent tremendous value relative to current alternatives on interest rates.
Put another way, the net present value of future earnings, assuming any decent earnings growth in the years ahead and continued low interest rates (as the Fed has indicated), is extremely good.
The reason the stock market has been able to manage a monster "stealth rally" the past three years is that the focus and fears have been on the tangential factors associated with viewing the stock market as a global "right direction/wrong direction" vote.
There have been plenty of days when U.S. stocks plunged on some news on Greek debt or Italian bond yields, or a rumor about a French bank. Bingo! That seems to prove that the long-term outlook for U.S. stocks is dependent on European trends -- and Europe clearly has long-term problems. Therefore, the outlook for U.S. stocks is poor.
This has been a constant refrain from so-called pundits.
The only problem is that that analysis has been wrong. During the past three years, the bottom-line fundamental of earnings has been improving. So, the stock market has grinded steadily higher all the while that pundits have been pointing out the obvious problems in Europe.
These pundits just don't seem to understand that spreads on credit default swaps in Europe ultimately only matter if they impact earnings for U.S. corporations. Just because stock prices dropped on a particular day when such analysis of such spreads was all the rage doesn't mean that factor will determine U.S. stock prices a year from now.
And, just because there was a credit implosion in the U.S. that crashed stock prices doesn't mean that European problems will do the same to stock prices in 2012. That will only happen if European problems lead to changes in long-term expectations for earnings for U.S. companies.
That could happen. We aren't totally discounting that possibility.
The next few weeks, however, the hard reality of earnings reports will trump the unquantifiable fears that Europe will somehow spark a sell-off in U.S. stocks.
What It All Means
Europe matters for U.S. stock prices, but only insofar as European issues impact current or prospective U.S. corporate earnings. The same applies to China, the Strait of Hormuz, and the price of cottonseed oil in Kazakhstan.
For example, Greece may well default. That could cause market disruptions and U.S. stock prices could take a temporary hit. The link to U.S. corporate earnings, however, is tenuous and limited.
If Johnson & Johnson (JNJ) manages to keep increasing earnings and dividends through a Greek default (as the company did through the 2008 stock market sell-off and U.S. recession) a Greek default doesn't imply a lower stock price for JNJ.
If JNJ, or the entire stock market, sells off on factors which are tangential and have little ultimate impact on earnings, that would simply present another buying opportunity.
U.S. corporation earnings are rising. Cash flow is stunningly strong. Stock buybacks are at very high levels. Dividends relative to earnings are at historically low levels. There will be dividend increases. These bullish trends will be reinforced with the earnings reports the next three weeks, and could well provide a boost to the U.S. stock market even if developments in Europe don't improve.
Buying stock in a corporation means owning a portion of that company. When the company's earnings rise, and when dividends go up, that increases the value of that portion of the company. Over time, those factors will make that stock more valuable.
The past few years, journalists have tended to view the market from a top-down "market of stocks" view with an emphasis on macro-economic issues. That has obscured the bottom-up, company-by-company earnings growth that has produced the stealth rally of the past three years.
Watch the earnings reports on individual companies the next three weeks. There may be good news.
-- Dick Green, Briefing.com
Read more: briefing.com