The price-to-peak earnings multiple advanced to 12.4x with last week’s bullish market performance. Following a few shaky weeks, US equities have brushed off European debt fears and turned in their best two-week performance in more than three months. Fourth quarter earnings results have given a big boost to the bulls during this time period. With most of the quarterly reporting period behind us, nearly 70% of stocks have exceeded analysts’ earnings estimates. Obviously, should corporate profits continue to improve, it will make it easier for companies to meet or exceed their full year 2010 earnings forecasts.
However, despite all of this good news, we must provide some context regarding the current earnings picture. Trailing twelve month reported earnings for the S&P 500 is still less than half of its peak 2007 level. Back then, earnings topped out at $89.22 per share and the S&P 500 was trading around 1500 with a P/E ratio of less than 17x. As of last week’s close, the trailing twelve month reported earnings for the S&P 500 was $39.54 per share, with a price-to-earnings multiple of 28x. Also, of note, the vast majority of credit crisis write-downs are now more than a year old, so they are no longer weighing down earnings. In the future, favorable year-over-year comparisons are going to get much tougher.
This is not to say that the stock market was cheap in 2007, but rather that—based on reported earnings—US equities are actually pretty expensive right now and investors have priced-in a lot of future earnings growth. With recent analysts’ estimates for 2010 S&P earnings coming in at between $75-$80 per share, it is clear that a substantial amount of further improvement is expected. We believe that this sort of growth is possible, but even should it be attained, that equates to a multiple of 15x. Any disappointment in these earnings forecasts could be met with a rapid and sharp downward movement in stock prices.
The percentage of NYSE stocks trading above their 30-week moving average has increased to 69% as of the close on Friday. Investor sentiment has rebounded quite strongly as it seems most market participants saw the recent dip as an opportunity to buy. Furthermore, many global investors see the US market as a relative safe-haven when compared to the risks associated with other developed economies, particularly the highly leveraged PIGS (Portugal, Ireland, Greece, and Spain) economies that threaten the stability of the Europe Union. The most pressing concern in Europe is in Greece, which has 20 billion Euros of debt coming due in the next two months. Without outside help, Greece cannot refinance this maturing debt and will default. However as John Mauldin’s weekly insight illustrates, Greece’s issues maybe small in comparison to the problems facing Spain. If an economy the size of Spain’s were it to need a bailout, the Euro would likely be doomed.
Even though Moody’s has warned that US debt may face a downgrade from AAA-status at some point in the future, for now, investors seem confident that the US is in better shape that Europe. However, few economists deny that budget tightening, tax hikes and tough choices await US policy-makers as well.
At this point, it appears that the correction felt in the equity markets in January has abated, as earnings surprises and merger and acquisition activity boosted stocks. However, we remain concerned that equity prices have gotten ahead of themselves and that a true correction could come at any time. We would not be surprised to see the markets trade within a tighter range than we have become accustomed to over the last year, as expectations for growth mesh with actual results.
Furthermore, we were surprised and pleased to see the Fed raise the Discount Rate by 25 basis points last week. This first of many tightening steps we expect to see over the coming year which signal a return to some sense of normalcy and is a show of confidence in the overall economy from the Federal Reserve. The market will be anxiously watching for clues of Bernanke’s plans on Wednesday as he testifies before Congress in his regular semi-annual monetary policy meeting.