S&P 500 Earnings Look Good For 4Q 2010, But Watch Your Step

Even though growth in the U.S. economy fell short in the second half of the year, corporate earnings are shaping up well for the fourth quarter. The aggregate of analysts' estimates are projecting a 14 percent increase for the upcoming earnings season -- below the 30 percent-plus gains a year ago, but still enough to send the market to levels we haven't seen since Lehman Brothers was still around. But if the recent past is any guide, pleasant earnings may not be enough to buoy the markets through first quarter 2011.

The expected growth in corporate earnings is broad based, spread out among many sectors, and that is great to see.

Best year-over-year growth for the fourth quarter is projected in materials and energy companies, both at 28.5 percent. Profits of consumer discretionary, information technology and telecom companies are all estimated to grow at 12 to 13 percent. Industrials are slated to grow 10 percent, and we should see small single-digit increases or decreases in utilities, consumer staples and health care. The latter two are being held back by household products and pharmaceuticals, respectively.

Within the financial sector, wide swings in different groups somehow net out to a zero change for quarterly earnings. Investment banks' earnings are supposed to be way down, while consumer finance companies are showing big gains. Big commercial banks also net out to zero change for the quarter.

This graph shows the earnings per share that the excellent StarMine Professional system assembles, as well as the year-over-year growth rate for the quarter's profits. (StarMine is a service of Thomson Reuters.) Year-over-year growth is in yellow, and LTM earnings per share are in green. At an index level of 1255, the S&P 500 is thought to be trading at 13 times earnings, which is in the middle of the range for this year (11.8 times in July to 14.5 times in January).

And you may have heard that the U.S. equity market is finally back out of the foxhole that we entered in September 2008 -- Lehman time. (Note the two red circles.)

Source: Google Finance
Professor Robert Shiller of Yale University, whose insightful scholarship has allowed us to dwell on exactly how much we have lost on our houses in the past five years, posits that the stock market is too high, or at least is trading above its average cyclically-adjusted price-earnings ratio. Versus an average of about 21 times since 1980, and 16 times for the extremely long term, since 1871, the S&P 500 is now valued at 22.8 times earnings. In October the U.S. market seemed a bargain by comparison -- his adjusted p-e measure was 18.8 times.

But as good as the mosaic of companies' earnings looks, I am concerned that stock prices are vulnerable to the macro picture. Not a crash, but a correction, a letdown. We saw this more or less every quarter in 2010 -- share prices running up, and deservedly so, on improving earnings, only to be deflated by macro developments, such as the crises in Greece and Ireland. (I wrote about this pattern a while ago here.)

What macro stuff do we have to worry about today? Well, the growth picture here is not very strong, observes my MoneyWatch colleague Mark Thoma. China is raising interest rates further, suggesting slower growth for not only them but everyone else; oil is back over $90 a barrel, up from $70 at mid-year; and U.S. mortgage rates are rising, from a low of 4.20 percent in October to 4.81 percent last week (although today they are about equal to a year ago). And we have a new Congress starting shortly, although I guess the markets' confidence could go either way on that.

So enjoy the markets during January, but be prepared for a new year reality check.