For the past month, much of the media attention focused on the financial markets has been about corporate earnings. They are important, because the foundation of our capitalistic system is the concept that individual investors can participate in the profits of these corporations. Without earnings, there are no profits to share.

Many of the media reports the past few weeks have been about how second quarter earnings reports for many corporations have been better than expected. In fact, a report from Thomson Reuters news service showed that on July 24, with 30% of the S&P 500 companies reporting, only 16% of the companies failed to meet earnings expectations. Seventy-six percent exceeded projections and the remaining 8% matched expectations.

Unfortunately for investors, whether or not a company exceeds its earnings forecast says nothing about its profitability. For example, consider this report from Money Daily: “After the bell on Tuesday, chipmaker Intel reported second quarter earnings results far ahead of Wall Street expectations. That was enough to give investors confidence that the economy was continuing to mend - albeit slowly - and that stocks - especially tech companies with strong balance sheets - would weather the storm and produce solid results.”

Based on that commentary, one might assume that Intel was reporting a profit. In actuality, Intel lost 7 cents a share. That compared to a gain of 28 cents a share for the same quarter in 2008. Wall Street was expecting Intel to lose 8 cents per share. So the reported loss was better than anticipated. Even though Intel lost money and overall earnings were down dramatically from the previous year, it was among those 76% of companies whose earning exceeded expectations.

Intel closed at 16.83 the day before the report. The next day it gapped up to open at 17.99 and it closed at 18.05 

In reality, earnings forecasts are not very important because the actual number can end up being far different than the forecast. The forecasts are the first glimpse of what the real quarterly numbers might turn out to be so they receive lots of media attention. Revisions made weeks later with more accurate numbers often fail to generate much interest or publicity.

A Jun. 19, 2009 report from Comstock Partners Inc. noted: “We are surprised to see so many analysts and portfolio managers discussing the first quarter’s earnings for the S&P 500. Almost everyone believes that the earnings have come in above the forecasts and the only disappointment came from revenue shortfalls.

“We wrote a report on April 16th (the beginning of 2009 first quarter earnings announcements) about a discussion in the Wall Street Journal on whether the $13 of estimated ‘operating’ earnings for the first quarter would hold up. We concluded that the earnings would not match the estimate and we quote from the comment, ‘we don’t expect them to reach the $13 estimated for the first quarter.’ Now that the earnings season has ended, the first quarter earnings are now a lot clearer and look to be just above $10. …”

As demonstrated with the Intel example above, the corporations and Wall Street benefit when earnings exceed forecasts. So it is to their advantage to make certain that their forecasts are ridiculously conservative. It is kind of like asking students to choose their own grades. Given that opportunity, not many will fail.

The reality of the current situation is that no matter what the media is reporting, corporate earnings are dismal. Earnings per share of the S&P 500 are at their lowest levels since the index was founded in 1936. 

Below is a chart that shows the quarterly P/E ratio of the S&P 500 based on trailing 12-month earnings. This information comes directly from Standard & Poor’s. At the end of 2008 (the last quarter for which final data is available), the P/E ratio of the S&P 500 was at 60.70, its highest recorded level. Although final data was not available to include in this chart for the past two quarters, on the Standard & Poor’s web site as of June 30, 2009 the P/E ratio of the S&P 500 (based on as-reported earnings) was reported as 134.01–more than double the highest level shown on this chart. Historically, the all-time average P/E ratio of the S&P 500 has been about 15.

A P/E ratio can be reflective of a company’s financial strength or weakness. It is calculated by dividing a company’s stock price by its earnings per share. Stocks with lower P/E ratios are generally assumed to be more attractive. While a low P/E is not a guarantee that a stock will perform well, it can be a useful tool to help assess earnings potential. Since the stock price also reflects the investors’ expectations regarding the growth and future development of a company, a high P/E can be the result of investors’ speculation.

Most financial advisors would recommend that their clients avoid stocks with high P/E ratios because it is an indication that the stock is overvalued and carries potentially high risk. For example, at the end of 1999 when the technology sector reached its highest levels of “irrational exuberance,” Microsoft (MSFT) shares were trading at about $60 with a P/E of 76. A year later the share price had declined to $23 and the P/E was 30. Today the share price is about $24 and the P/E is about 14.

In this instance, the high P/E ratio of the S&P 500 is primarily reflective of a lack of earnings rather than of high investor expectations. Let the significance of that sink in for a minute or two. Standard & Poor’s describes the index as: “the best single gauge of the U.S. equities market, this world-renowned index includes 500 leading companies in leading industries of the U.S. economy.” And since peaking in the third quarter of 2007, earnings for this icon of the U.S. stock market have fallen more than 95%. Never in the 73-year existence of the index have earnings been at this low level. 

In spite of the fact that earnings have never been this low, the S&P 500 has risen more than 40% since bottoming at about 676 in March 2009. If the index were currently trading at the historical average of about 15 times earnings, the S&P 500 would now be well under 100, rather than approaching 1,000.

What does all this mean for Strategis Financial Group and its clients? For us it is just additional evidence that market risk remains  high. At some point improving technical indicators could cause us to begin to ease back into the markets no matter the P/E ratio of the S&P 500. But because so many fundamental indicators remain negative, re-entry into the equity markets must be cautious and measured.
F.S.