S&P 500 at 1200: Will Corporate Earnings Support Further Gains?

Earnings reports for 2010's first quarter are coming in fairly strong, and share prices are responding accordingly, rising about three percent since the start of the news season three weeks ago, and that's after the Goldman news and the volcano thing took some of the wind out of investors' sails. So -- there's clearly a recovery underway, which seems likely to continue, but can stocks keep pace? Most observers see the short-term trend as solid, but several serious analysts think the good recovery is already priced in.

In keeping with the improving economy, analysts' estimates of 2010 earnings have risen since the first quarter. On January 25, StarMine Professional, a Reuters company, reported an aggregate estimate for the coming 12 months of about $79 per share, placing the valuation of the S&P 500 at about 13.9 times on the next 12 months' profits.

The proportion of companies reporting favorable earnings surprises these days is north of 80 percent. But don't get too excited about that: earnings reports are a cat-and-mouse game that company managements play with the markets, so analysts can have something to comment on, and investors can ooh and aah for a day or two. But in a typical quarter something like 60 percent of companies "beat" their estimates, and considering the hole the economy is coming out of in 2010, anything other than surprises to the upside would be a disappointment.

Adding up all the individual company estimates, StarMine tells the analysts are expecting about $86 per share for the coming 12 months; with the S&P 500 at roughly 1,220, market valuation is thus 14.2 times. From the first quarter to the second, the rate of earnings growth -- recovery probably says it better -- for the forward 12 months is stable at 32%. Estimated earnings are up eight percent, and the market has responded with an 11 percent gain.

This link should take you to a graph showing the path of the S&P 500 since the first quarter earnings season. Share prices fell on fears that a financial black hole from a collapse by Greece might pull the rest of Europe in after it, but the U.S. market got back on track.

To summarize the cause and effect of the last couple of quarters: earnings have marched ahead, at a pace fitting a recovery from a deep recession, and the markets have moved up with them. Net net, share prices seem no more or less rich than they were last quarter.
But as stockbrokers like to say, we're investing in the future of this economy, not the past. Is the U.S. stock market cheap? Expensive? Neither? No one knows for sure, of course. Those observers of a trading bent look at economic gains further out, and assume the market will be happy to oblige with higher share prices. Watch CNBC for a few minutes and you will get the idea.

Those inclined toward deeper analysis, however, are more skeptical. David Rosenberg, strategist at Gluskin Sheff + Associates in Montreal, points out in his daily letter from April 26 (sorry, no links) that there is plenty of ground the U.S. economy still has to make up:

Sentiment in the U.S. is so robust that nobody seems to recall that consumer confidence in April fell to its lowest level in six months ([the U of Michigan survey is] down to 69.5 from 73.6 in March - in real sustainable economic expansions, it averages just over 100). But there's little doubt [of] the widespread confidence in the economy's new-found verve, although the real tests lie ahead as all the stimulus from the Fed's quantitative easing program, tax refunds and housing credits fade away. For the coming week, investors face a real test too with the Fed meeting, the Q1 GDP report and $129 billion of new Treasury supply hitting the market.

Oh yes - how can we forget? There is supposedly a sustainable recovery going on and an improvement in overall credit conditions and yet somehow the FDIC still managed to shutter seven failed banks on Friday. That brings the number of bank failures to 57 for the year - well ahead of the 2009 pace.

Click on the graph for a larger image
The black arrows were added by me, showing several recent low points in the economic cycle.

Here's the interpretation of Shiller's graph by the aforementioned, perspicacious David Rosenberg:

The Shiller P/E ratio is currently more than 30% above historical norms... The S&P 500 is basically priced for a return-to-peak earnings by next year and the VIX index, being where it is right now (at 16.3), is testament to the view that Mr. Market is attaching an extremely high probability of this happening. With margins already massively expanded, unit labour costs being cut a record 4.7% YoY, the financial share of earnings surging to their highest level ever, and the fact we are past the peak rate of economic growth for the cycle, the widespread view of a sustained V-shaped recovery in corporate profits will be put to the test.

Given March housing starts and new and existing home sales, the macro data appear to be confirming what the equity market has already been telling us: The economy is firing on all cylinders. On balance, we think the window is closing for a continued equity rally on the back of an improving macro backdrop alongside a patient Fed. With the implications of financial regulatory reform likely to turn investors' attention away from the current cyclical recovery toward the secular outlook, we expect they will also begin considering the magnitude and nature of fiscal tightening in 2011. All of these issues should lead to some dampening of the current optimism in markets and at least a shallow near-term correction.

[T]he risk of a market correction is greater today than it has been since the rally began. Bullish investor sentiment is at levels that have historically warranted a cautious near-term outlook. Current low levels of volatility (a signal that investors are complacent) could be poised to rise again. [We] are likely to hold higher cash balances than we have over the past 12 months in order to take advantage of an increase in volatility. Although markets have come a long way from last year and optimism is on the upswing, now is not the time to get giddy.