Corporate earnings are the foundation of the stock market, and the multiple of earnings that investors are willing to pay for them are the frame of the building on that foundation.
To determine how much the market is worth, we start with an estimate of earnings and then try to figure out how much investors will be willing to pay for those earnings in the future.
At the moment, forward looking earnings estimates are being slashed as equity analysts calculate the impact that the current economic contraction will have on revenue and profitability.
The forecast for first-quarter earnings growth on the S&P 500 has declined to -31%. All 10 sectors of the S&P are now expected to show a year-over-year decline in earnings.
A year ago, equity analysts were criticized for not cutting earnings estimates fast enough as the recession deepened. The consensus first-quarter earnings growth rate didn’t turn negative until late November.
Are We Oversold?
Now, based on the results from the fourth-quarter earnings season, it appears analysts may be rushing to cut estimates too deeply. Of the 474 S&P 500 companies that have reported fourth-quarter results, 287 beat consensus forecasts while 147 missed.
What this means is that despite harrowing share price declines and analyst downgrades, many companies are just not as badly affected by the recession as analysts have come to believe.
Unfortunately, due to the huge misses by big banks recognizing losses on toxic credit assets, aggregate results for the index are missing expectations by 23%. Strip away these weak performers and the earnings power of the rest of the economy can reassert itself, giving us a better idea of where stocks may head.
This is what researchers at brokerage UBS AG (UBS) have done by assuming laggards Citigroup (C) and American International Group (AIG) will stop reporting heavy losses or will be removed from the S&P 500 index entirely.
While this seems crazy initially, the fact remains that both of these companies are basically nationalized institutions with fast declining market caps. After actions taken on Friday, the U.S. Government is now the largest single shareholder in Citigroup with a 36% stake, while AIG has just received a fourth equity injection from the government.
The S&P index committee requires constituent companies maintain a public float of at least 50% of total shares outstanding and maintain market caps in excess of $3 billion. AIG’s market cap has already fallen to just $1.1 billion. As part of its original bailout last September the Federal Reserve received a warrant for 79.9% of AIG’s equity, so it could pull the trigger at anytime. Citigroup’s market cap is at $8.2 billion and falling fast.
Given current and expected future circumstances, I am looking for S&P 500 earnings to be cut in half to less than $42 per share over the next year. But if Standard & Poor’s removes the worst-performing banks, the EPS of the index can shoot up dramatically. UBS analysts are looking for S&P 500 earnings per share of $68 in 2010 in this context. Applying a 16x multiple to this, which is the average over the 1960-2007 period, they see the S&P 500 returning to the 1100 level.
Not Until Confidence Returns
While that’s obviously attractive now — how times have changed, right? — the fact is that a 16 PE is probably not likely to emerge. Price/earnings multiples measure confidence, and if banks are nationalized and industrials are teetering it’s unlikely that investors will be willing to pay up. In fact it’s more likely that investors will revert to single-digit PEs seen in the 1970s. Even if you go for a 10 PE, that still puts the target for the S&P 500 at the 680 level.
In short, even if you are fairly optimistic on S&P 500 earnings it’s hard to make a case for the market moving a lot higher now. To learn how to trade profitably in these conditions, check out my Trader’s Advantage newsletter.
This article was written by Jon Markman, contributor to InvestorPlace Media. For more actionable insights likes this, visit www.InvestorPlace.com.
