Earnings Dilemma

Story Highlights

• As recession talk intensifies in the US, many are pointing to the dip in third quarter earnings as ample evidence for pessimism.
• A close look at the numbers, however, reveals reasons to stay bullish on stocks.
• Despite current earnings disappointments, stocks remain at bargain basement prices compared to alternatives.

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What's up with earnings? Or, maybe we should say, what's down? For the first time in over five years, year-over-year earnings growth declined in the third quarter—to the tune of -4.4%. This sparked a spate of pessimism, with 2008 recession forecasts aplenty. In fact, Wall Street has recently gone from expecting a 12% rise in fourth-quarter S&P profits to a modest 1.7% gain.

But like all financial stats, understanding what makes the data tick is as important as the numbers themselves. A closer inspection reveals corporate earnings are not as bad as they seem.

Since earnings results came in well below forecasts, a good first step is to understand why. As of November 27th, 480 companies in the S&P 500 reported earnings, representing 98% of the market value of the index.

• 64% of reporting companies beat previous estimates
• 12% were in-line
• 25% missed

If the majority of companies beat their forecast, then the minority of those who missed expectations (only 25%) must have missed big time in order to sink earnings so low. Clearly, the result of a painful quarter for Financials. The largest sector of the economy by market cap, Financials stocks made headlines all quarter as fallout from asset write-downs and other related credit problems emerged in company results. So it should be little surprise Financials has suffered the biggest downgrade in expectations looking ahead, from a 10% gain to a 26% decline next quarter (about the same as the sector's third-quarter results).

These write-downs, in our opinion, are not only highly overwrought, but are also predominantly one-time events. Asset write-downs are largely issues of accounting. In fact, business operations and cash flows for Financials excluding the write-downs were brisk last quarter.

While this alone makes the situation feel more benign, it may even have bullish ramifications. As the Financials companies eventually recover and "write-up" their assets, comparative earnings in future quarters could be blockbuster. In fact, if you looked at aggregate earnings excluding Financials, growth was relatively strong and would have easily posted in positive territory.

Ok, that makes sense, but how could US GDP come in at 3.9% in the third quarter while earnings sank? Don't those numbers contradict each other? The reason is GDP doesn't measure accounting quirks like asset write-downs (where financials took their big hits). GDP looks for the absolute level of domestic economic activity, which surged past expectations last quarter. That doesn't mean GDP is a better metric than earnings, but in this case it does reveal a dimension of economic strength earnings couldn't.

For that matter, why look at only one quarter's worth of earnings anyway? Just like it's crazy to take one day's stock returns and predict a trend, the same is true for quarterly earnings, which can be erratic. Taking a larger view, 2007 earnings are set to grow well over 5%—a very fine result despite a wonky third quarter.

All that seems well and good, but in the end aren't falling earnings today all that matter? Don't poor earnings undermine the whole reason to own stocks? Not really. First, there are plenty of times earnings growth has decelerated and stocks charged ahead. That's because stock prices and earnings aren't necessarily the same, nor do they always move in the same direction. (Think back to 2004 through 2006, in which blockbuster earnings seasons led to modest stock returns.)

When thinking about demand for stocks, it's wrong to only think about their value in a vacuum, or compare them only to each other. Stock prices are as much about their relative value to alternative uses of investment capital as their perceived intrinsic value.

Are stocks still a strong relative value to bonds, cash, or other alternatives? The answer is, resoundingly, yes. But how do we easily compare them?

Flipping the stock P/E ratio gives us the E/P, also called the earnings yield—a metric enabling us to compare the relative yields on stocks and bonds. Most of the time—even in bull markets—bond yields are generally above earnings yields. Today, however, earnings yields are higher than bond yields throughout the world—a unique phenomenon. As of October 31st, US stocks yielded 6.7% compared to 10-year treasury yields of 4.5%. That's a spread of over 2%! (The spread is probably even wider now considering the big drop in bond yields over the last month.) Thus, stocks are still very cheap relative to alternatives like bonds.

Earnings might look bad today, but with the right perspective things remain in good shape for stocks. Stay bullish.

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Sources:

• Thomson Financial
• The Wall Street Journal, "Industry-by-Industry Quarterly Earnings, Companies reporting as of November 22, 2007"
• The Wall Street Journal, "Prophet Warning: Analysts Seem Still Too Upbeat" By PETER A. MCKAY. November 28, 2007 https://online.wsj.com/article/SB119622059117206279.html