Earnings Streak Snapped; How Pricey Are Stocks?

My nomination for the greatest story never told is this under-reported tidbit, via AP:

"For America’s top 500 companies, the absence of extraordinary earnings
news this past week pretty much guarantees 18 consecutive quarters of
double-digit profit are over.

Wall Street analysts say fourth-quarter
results are running just about on par with historical averages. As of
Jan. 31, with 57 percent of S&P components reporting, companies
have posted profit growth that has averaged 8.1 percent, the rating
agency said.

But measure the latest results against the third-quarter’s 23 percent performance and the fourth quarter pales in comparison."

Earnings have been on an astonishing tear. For the past 18 quarters, markets have seen a spike in reported corporate profitibility. We attribute this run up to several factors:

– Materials and Energy profits due to underlying commodities price gains;
– Banking sector profitibility courtesy of ultra low rates;
– Financial sector gains via huge liquidity leading to IPOs, M&A, takeouts;
An Unprecedented Mass of Buybacks

There can be no doubt that corporate balance sheets are better than they have been in decades. Earnings quality is also notably improved.

But do not confuse financial engineering with cheap stock prices. Like so much else we see lately, valuation is also a bifurcated affair, with the cheapest large stocks making the rest of the S&P500 appear less pricey than it really is. 

Blame it on Market Cap.

This is in some ways somewhat parallel to what happened during the run up in 1999 and 2000. A small handful of megacap stocks drove the indices higher, while much of the rest of the market under-performed. If fund managers didn’t own the nineties equivalent of the nifty fifty, they didn’t keep up with their benchmarks.    

Today, instead of megacaps driving price, they are driving valuations. Those are the findings of Dresdner Kleinwort Group:

"Recent research by Dresdner found that only six very big
make up the top decile, or 10th, of the market value of
the Morgan Stanley Capital International Europe Index. What’s
more, the six — Royal Dutch Shell Plc, HSBC Holdings Plc, BP
Plc, Roche Holding AG, Total SA, and GlaxoSmithKline Plc — have
an average weight-adjusted P/E ratio of 11.2. The top 30 percent
of the European stock market’s value consists of 26 stocks with
an average weighted P/E ratio of 11.9, according to Dresdner.

Now for the kicker. The bottom 10 percent — which contains
293 stocks — is trading at 16 times projected earnings . . .         

Ditto the U.S., where just four companies — Exxon Mobil
Corp., General Electric Co., Microsoft Corp., and Citigroup Inc.
— make up the top decile of the Standard & Poor’s 500 Index. And
a mere 19 companies with an average P/E of 14 comprise the top 30
percent of the market’s value. By contrast, the bottom 10 percent
consists of 206 companies with an average P/E of 16.2, according
to Dresdner."

If we combine these two issues — earnings decelerating below double digit gains, and valuations appearing reasonable only due to a skewing effect of 4 major stocks — you have a recipe for an expensive, not a cheap market.


S&P’s Corporate Growth Streak Snapped
Big U.S. Companies Not Seen Continuing Double-Digit Growth Pattern
Joe Bel Bruno
AP Business, Friday February 2, 4:49 pm ET

Stocks Look Cheap? Not Without the Big Guys
Michael R. Sesit
Bloomberg, Feb. 6 2007

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What's been said:

Discussions found on the web:
  1. Barry Ritholtz commented on Feb 6

    Remember this caveat:

    Cheap stocks can get cheaper, and pricey stocks can get pricier . . .

  2. dblwyo commented on Feb 6

    Very interesting – had to happen sooner or later though, right ? In the bigger BigPic this closes a couple of loops – with growth not being organic companies have lots of cash flow but don’t need to invest in equipment or hire (hence the low job creation). And the repair of balance sheets, highest share of GDP for profits post-war and the buybacks. Nothing in there about sustainable performance though.

    In the bigger BP couldn’t we also point to Gross’s recent column you tagged ? As I get it he’s turned the argument on it’s head – instead of earnings and operating performance driving valuations the huge liquidities built up have taken on a life of their own as they look for returns.

    One more really distant loop connection – our huge trade imbalances, especially with China, means that it MUST be offset by financial assets (hence their exchange reserves) and so far (thank god) they’re re-cycling them into US assets. Which comes full circle because it means that as they buy gov’t securities funds flow in the market toward PE/LBO/M&A buyouts, hedge funds, mutual funds, etc. Yet companies aren’t coming to public markets because they don’t need money.

    A self-sustaining vicious circle ?

  3. alexd commented on Feb 6

    At some point the relationship of a populace where wages have not gone up enough versus cost of goods and services will come into play.

    No immeadiate matter if you make luxury goods for that will sustain itself for a long period, but a bit more problematic if you make goods that are below luxury class and above necessary. If the majority of the populace does nto have the money or credit then they will reduce their consumption of things that they can live without.

    Buy luxury goods, collection agencies, energy, insurance, med/pharma.

    When financials turn down look at your underwear! (shorts)

    Be well

  4. sw commented on Feb 6

    Hey Barry,

    Am I crazy or did I see you in a Mercedes ad last night? Pretty classic spot, congrats.

  5. Barry Ritholtz commented on Feb 6


    I know not what you refer to (but I do have an old 560 SL)

  6. winjr commented on Feb 6

    Regarding stock buybacks, it just occured to me that, as the earnings season begins to wind down, it seems as if fewer buybacks have been announced than in previous quarters. Is this accurate, or am I simply not paying enough attention?

  7. james commented on Feb 6

    The other story that most are ignoring is that the P/E most of Wall Street is using is forward OPERATING EARNINGS – not trailing net earnigns. How big of a difference is this? Check Ben Inker of GMO’s study on the subject – how about 25%! Comparing forward operating earnings to trailing net is like the late 1990’s when people relied on forward EBITDA estimates to justify investing in fiber companies.

    Finally, even trailing net earnings are comprised of record high profit margins at peak cycle earnings. Normalizing all of these factors generates an SPX P/E of about 25 – before accounting for the cap distortion. Small caps are even more overvalued. None of this will matter….until it does. As Ben Graham said, the market is a voting machine in the short term. However, over time the weighing machine will eventually dominate – and that machine has the market about 40% above normalized value.

  8. sw commented on Feb 6

    Oh, sorry about that. I must have gotten you confused with someone else. I’m much more familiar with your word than your face. :)

  9. Bluzer commented on Feb 6

    “If we combine these two issues — earnings decelerating below double digit gains, and valuations appearing reasonable only due to a skewing effect of 4 major stocks — you have a recipe for an expensive, not a cheap market.”

    But can’t we also conclude, perhaps more profitably, that the big caps are incredible values here and maybe the perfect place to hide should the much anticipated recession occur? And if the fed, stealthily, continues pumping and defers or even denies the recession then we come out way ahead? The perfect hedge – they seem to be. What am I missing?

  10. Dirk van Dijk commented on Feb 6

    I would point out on the other hand that the slowing to a single digit growth rate of earnings is mostly due to the effect of those mega caps. Of the more than 60% of S&P 500 firms that had reported throught the close of Thurs 2/1, the median year over year growth rate was 13.2%. So far there have been 199 positive surprises vs. only 70 disappointments, with 34 hitting expectations right on the nose. Materials and Industrials are showing the best growth while Utilities and Tech the worst. Energy had been showing very strong growth as the oil service guys reported early, but the median growth rate has slowed sharply as the integrateds and the E&P firms got around to reporting. Measured by what most firms are reporting, we are going to have yet another quarter of year over year growth. The slowdown in total earnings is mostly a function of EXTREMELY tough comps for the likes of XOM, CVX and COP.

  11. Teddy commented on Feb 6

    Dirk, I would also add that if the Mahquette was a soap, they’d quall it the “Guiding Light” and you’d be a star. And btw, is the j silent?

  12. Dirk van Dijk commented on Feb 6

    Thanks, I think. Yeah the spelling is the origional dutch (I was born here, but my dad was born in Holland). In dutch when a Y has the 2 dots over it in script it is translated into print as ij, so it is pronounced van Dyke (and I can trip over an ottoman just as well as Dick can, but otherwise he has me beat in all talent areas)

  13. Eclectic commented on Feb 6

    I must say, BR… sometimes you ascend to a place of sublime, pristine analytical excellence — a sort of Valhalla — that literally brings tears to my eyes.

  14. Teddy commented on Feb 6

    Dirk, ya got sum good jeans there just like my Mrs. and don’t sell short.. yourself. Ya doin well.

  15. Polly Anna commented on Feb 6

    “So far there have been 199 positive surprises vs. only 70 disappointments, with 34 hitting expectations right on the nose. ”

    Let’s see, this means 199 beat by a penny, 34 hit on the nose, and 70 couldn’t even fudge their numbers enough to hit the number analysts have been emailing them for months. :)

    But all this stuff only matters if you still believe that earnings have anything to do with the reasons these stocks are going up or down.

  16. Eclectic commented on Feb 7

    What would you get if you mixed a little Duke Ellington and some Peter Gunn, maybe with a dash of Quinn Martin and a splash of Book ’em Danno, and then shook it all up over ice with a Wagner twist?

    Zis close?


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