Earnings Returning to Pre-Crisis Levels

First quarter earnings season is finally upon us, as Alcoa (AA) kicked things off with a bang today. Over the next four weeks, 65% of the companies in the benchmark S&P 500 index will report results. Currently, the consensus estimates Q1 S&P 500 earnings per share of $17.07, representing a 39% increase over last year. According to Credit Suisse analysts, this forecast is consistent with the forecast of increased economic activity.

If the consensus is close to being right, the S&P 500 should see total quarterly earnings of about $160 billion — which will mark a return to levels last seen in the third quarter of 2008. This means that the largest companies in the economy have seen their earnings power finally return to the levels that prevailed before the Lehman Bros. collapse.

Also, Q1 ’10 is shaping up to be the second consecutive quarter of year-over-year earnings growth for the S&P 500 after nine straight quarters of declines.

At the sector level, the highest estimated earnings growth rates are found in the financials, materials, and consumer discretionary sectors followed by technology and energy. This is to be expected, since all are considered “cyclical” sectors and should continue to do well in these early stages of economic recovery.

Drilling down to the industry level, there are a few standouts. Within the financial sector, regional banks, insurance, and investment banks/brokerages are the largest contributors to total earnings growth. In the other areas, chemicals, metals mining, and integrated oil and gas are the highlights. I suggest that you continue to focus on these groups over the coming months.

Overall, from a valuations perspective stocks are not overpriced relative to earnings. The current 2010 price-to-earnings multiple for the S&P 500 sits at 14.7x, just below the historical average of 15x. Based on current 2011 earnings estimates, stocks are trading at 12.1x. Based on this, along with continued strength in medium-term measures of market breadth, there is little doubt in my mind that we should see stocks make continued gains over the next 12 months.

Indeed, Andrew Garthwaite at Credit Suisse believes that the consensus revenue estimates are too low. Upside surprises from actual results should help support stock prices in general. As for the cyclical stocks specifically, Garthwaite notes that they traditionally peak one month after the ISM new orders index peaks. He expects this to happen in the latter part of the second quarter.

Based on this, we remain within a bull market that should last at least another year led for at least the next six months by cyclical issues like U.S. Steel, Intel (INTC), and Microsoft (MSFT).

Investors should be well positioned for this with ETF holdings such as the SPDR nsurance (KIE) and the iShares Regional Banks (IAT), as well as individual basic materials and tech stocks like Balchem (BCPC), Apple (AAPL) and Cognizant Tech (CTSH), shown above. The market is in the process of having its valuation re-rated higher, and these companies are at the forefront of the action due to their innovation, low debt and solid sales efforts — nothing very magical, just hard work and imagination.

Of course, some earnings reports are just starting to trickle out, and they have been tipping in our favor so far, which is nice. Schnitzer Steel (SCHN), which is a component of the MV Steel (SLX) fund that I have recommended, reported on Wednesday after the bell that it beat earnings estimates by 14 cents and also beat on revenues. Sales rose 38.6% year over year. The company said it was their best quarter since the industry downturn began two years ago, and that it is seeing “steady improvement in demand” everywhere but the U.S. west coast. Executives said they had achieved their success with more expense-cutting and price increases. Any company that can raise prices in a generally deflationary environment is likely to do well, so this probably bodes well for the rest of the steel group.

Earlier on Wednesday, Family Dollar (FDO), a large discount retail chain and one of the companies in my recommended list, reported better-than-expected results in its fiscal second quarter an boosted guidance. Shares bolted 3.5% higher on big volume. FDO said it enjoyed a 3.6% increase in comparable store sales, which along with cost-cutting helped it log a 35% increase in earnings per share on a 5% increase in revenue. Margins were the best since 2006 in the FDO earnings report, and the company said the beat came from increased customer traffic and higher average sale per transaction; electronics, home products and consumables were the leading categories.

FDO by the way was the very best performing stock in the S&P 500 during calendar 2008, so the fact that it can do well in both a bear and bull market says a lot about the soundness of its business. Family Dollar earnings were well-watched because of this.

The company was founded in 1958 by a 21-year-old entrepreneur who became obsessed with the concept of operating a low-overhead, self-service store in which all goods cost less than $2. One of founder Leon Levine’s innovations was a floor plan that was identical in every store, so his low- to middle-income customers always knew where to go for goods no matter where they were shopping. It now operates 6,600 stores in 44 states and from its headquarters in North Carolina. FDO is a buy on pullbacks of 2% to 4%.

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