Are Corporate Earnings All They're Cracked-Up to Be?
Those that remain in the optimistic camp, especially media pundits, hang their hat on the fact that corporate earnings have been strong. But it takes more than numbers to justify high stock prices. It is equally important to determine why earnings have been strong and whether they are sustainable.
As put so succinctly by Lance Roberts of Streettalk Advisors in his article "Presidential And Decennial Cycles - What About 2012?": "This earnings boom cycle was skewed heavily by accounting rule changes [mark-to-market], loan loss provisioning, tax breaks, massive layoffs, extreme cost cutting, suppression of wages and benefits, longer work hours, a plunging dollar, extraordinary government stimulus and solid international growth."
I stated in the April 4, 2011, Weekly Market Update, "In March 2009, trailing 12 months earnings per share, adjusted for inflation, for the S&P 500 companies was $7.14. This was the lowest earnings per share number, adjusted for inflation, since January 1933. So, as profits improved in 2010, it is only logical that the increases will appear huge when comparing to 2009 earnings depressed by the greatest economic downturn since the Great Depression."
Let's also go back and look at some predictions from the beginning of the year and see how they changed as the year progressed. At the end of January 2011, Howard Silverblatt, Senior Index Analyst with Standard & Poor's, predicted S&P 500 2011 Net Earnings of about $96 per share. By June his estimate had dropped to about $91 per share, and his recent prediction is for close to $89 per share. In January of this year the Federal Reserve estimated Gross Domestic Product (GDP) for 2011 would be 3.4 - 3.9%; by April this dropped to 3.1 - 3.3%; in June it fell to 2.7 - 2.9%; and this month they revised their estimate lower to 1.6 - 1.7%.
Does anyone see a trend in these estimates, both for S&P 500 earnings and U.S. GDP? Now we need to apply a little common sense. In order to justify the current price of stocks, we would need to expect record high profit margins to continue into the future. However, with un- and under-employment still over 16%, a declining real estate market with almost 25% of all homeowners with a mortgage underwater (owing more than their house is worth), and therefore no more water in the well to borrow from, it is logical that domestic demand would fall.
And the U.S. depends on Europe for 20% of our exports. With the European Union embroiled in sovereign debt crises and a stalling economy, reporting GDP growth of only 0.2% in the third quarter 2011, a recession seems imminent. The problems in Europe will spill over, reducing their demand for our goods and services. The financial implosion in Europe is likely to drive investors into dollars. A stronger dollar will reduce foreign profits that contributed significantly to previous higher corporate earnings.
Corporations have cut expenses and employees to the bone. As we approach a global recession and demand continues to drop, corporations can no longer cut expenses to boost profits, so common sense tells us that profits will fall. When profits begin to drop, it will become apparent that stocks are in fact over-valued, and with few prospects for near term profit growth, stock values will plunge.
This shortened Thanksgiving week will have more excitement than usual as the "supercommittee" in Congress struggles to satisfy the mandate to come up with a measly $120 billion in annual deficit reduction for ten years. How long will it be before we realize that the numbers here are inconsequential? Until Congress decides to get serious about our deficit spending, the debt overhang will drag on our economy.
Last week the S&P 500 Index closed at 1,216, down about 3.8% for the week. The yield on the 10 year Treasury note ended the week slightly down at 2.01%. Oil closed slightly down at $97 per barrel. Gasoline prices ended the week at $3.36 per gallon. For those who enjoy Tunica, the yield on one-year Greek debt hit 240% last week.
Discussions in Europe continue as a solution for sovereign debt crises in Greece, Portugal, Italy, Spain, and maybe even France seems elusive.
