Estimates for Q2 prove too pessimistic
By Joseph V. Battipaglia, CBS MarketWatch.com
Last Update: 11:34 AM ET July 23, 2001
NEW YORK (CBS.MW) -- In April, 2000 I forecast that earnings would be the sole driver of stock prices and that price-earnings multiples had "already expanded to reflect good news on inflation, lower interest rates, the peace dividend, and the return of government fiscal discipline."
Unfortunately, this has proved to be all too accurate. Since the end of last year's second quarter, the S&P 500 (SPX: news, chart, profile) is off 18 percent. So too are earnings.
Based on First Call's data, second quarter 2001 earnings are expected to fall 18 percent versus the same period one year ago. A growing economy drives the bulk of the increase in S&P 500 earnings, while changes in productivity, margins, cost of capital, differing degrees of leverage, and stock repurchases may explain the rest. I am confident that an improving economy in the second half of 2001 and 2002 will provide a much improved tone to the U.S. equity markets.
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What about today's lofty multiples? Do they not dampen the bull case in the near term? The answer is "no" for the simple reason that there is no fundamental change on the inflation front that points to a long run deterioration in the value of financial assets - particularly equities.
Shorter term, it is possible that as we work through the current earnings recession, stocks will rally on the anticipation of returning growth creating a short-lived upward distortion in multiples before returning to trend. This is exactly what happened in the mid-eighties, early 1990's and the Asian financial crisis where multiples rose strongly for a brief time before returning to their longer-term trend.
Consider, for example, the 50 percent rise in the forward S&P multiples during the mid eighties earnings recession and the 25 percent rise in multiples during the last recession - both increases were well above the 5.2 percent annual rate of growth in multiples over the past 20 years.
Did multiples remain suspended at lofty heights permanently? No. But they did rise temporarily until an eventual recovery in earnings "filled in" the difference.
Since underlying trends in inflation have a direct impact on the value of financial assets, it is worth noting that over the past twenty years, the U.S. inflation rate has fallen from almost 11 percent in 1981 to today's 2.4 percent - a 7.2 percent annual rate of decrease. On the other hand, the multiple on forward S&P 500 earnings rose from rose from 7.6 times earnings in 1981 to 21.4 times today - a 5.2 percent annual rate of increase.
History also supports the case for higher multiples during times of low and steady inflation. The 1960's, for example, routinely saw multiples in the upper teens and low twenties before the 1970's arrived and ushered in an era of massive inflation, stubborn recessions, as well as political and social unrest.
To a great extent, the bull market of the 1980's and 1990's resulted from a rebuilding of the global financial system emphasizing freer trade and open access to foreign markets, greater competition within the U.S. and among our trading partners, an unlocking of resources though governmental privatization and deregulation initiatives, the end of the "Cold War" and the rapid adoption of democratic principles worldwide.
In addition, capital markets matured and expanded throughout the world providing capital and liquidity for investment in infrastructure, capacity, and development of new sources for raw materials. The combined effects of these efforts resulted in stable prices for commodity and intermediate goods while consumers enjoy the benefits of intense competition at the wholesale and retail levels. For these reasons, price stability should remain and provide continued support for financial asset values.
Earnings recovery, therefore, is the most important factor for the near term market performance.
Fortunately, positive news on this front is beginning to emerge. Second quarter earnings are coming in ahead of expectations. To date, 43 percent of S&P 500 and NASDAQ 100 companies have reported second quarter earnings according to a report issued Friday by Thompson Financial.
The report also shows that 88 percent of S&P 500 companies have met or exceeded expectations. Ninety-two percent of reporting NASDAQ 100 companies reported results in line or above expectations. Lastly, small to mid-capitalization issues (market capitalizations under $10 billion) are performing on cue with 80 percent of these companies reporting results at or above expectations.
The important take away from the preliminary earnings data is that it appears that for the second straight quarter, estimates have been overly pessimistic. This bodes well for future revisions to the earnings data and it is now likely that the trough in forecasted earnings is behind us. While I expect the third quarter to prove difficult yet again, the trough in projected earnings is likely behind us. More confirmation on the economy and gradual improvement in earnings is all that is left to lift equity prices from here.
Last week, Alan Greenspan weighed in on the economy and expressed optimism that the economy has bottomed.
The cumulative data to date supports this, as confidence improved, sales of durable goods remain healthy, and the consumer is in a buying mood.
Strong increases in the monetary aggregates, tax cuts and rate cuts coupled with lower inflation (thanks to easing energy prices) have driven real short-term interest rates to low levels. I continue to believe that the Fed has begun the process of easing off the monetary gas and will likely conclude its efforts with a 25 basis point cut at the August meeting. |
