ING Says Earnings Still Matter

ING has an interesting study on earnings and how the market seems to be considering them.  The firm is surprising upbeat, primarily due to today's valuations.

Earnings Matter After All
by Brian Gendreau, Ph.D., Investment Strategist

In recent weeks, the stock market has begun to get over its intense focus on oil prices and started to pay closer attention to corporate earnings.

Companies whose earnings have beaten consensus estimates in the second quarter have been rewarded with increases in their stock prices relative to the market, and companies that have missed numbers have seen their stocks crushed. The market as a whole, however, now seems to be distinctly undervalued at today’s prices if even a cautious version of consensus earnings estimates proves out.

Oil Prices Have Driven the Stock Market Lately


As of August 11, 449 companies in the S&P 500 Index had reported their earnings for this year’s second quarter, so we are almost all the way through the earnings season. Combining the earnings announced so far with consensus estimates for those that have not yet reported, earnings look like they will have declined by about 22% in the second quarter relative to their levels of a year ago. Moreover, average second quarter estimates have been declining steadily in recent weeks.

This sounds dreadful, but aggregate earnings mask details that suggest some grounds for optimism.

Stocks Have Been Reacting to Second Quarter Earnings

First of all, a large majority of companies have reported earnings that have exceeded expectations. As of August 11,66% of companies that have reported have topped estimates, 10% have matched and 24% have missed estimates. Second, the drop in earnings has been concentrated in two sectors: Consumer discretionary (which includes the troubled auto and homebuilding industries) in which earnings are estimated to have declined an estimated 56% from year-ago levels, and financials, in which earnings are estimated to have fallen by 86%. (Earnings are also estimated to have eased in the telecommunications sector, but by only 3%.)

Earnings in most of the non-financial sectors appear to have grown in the second quarter. Earnings appear to have been especially strong in the consumer staples, energy, and technology sectors, where they are in each case estimated to have grown at double-digit rates. Moreover, there is little evidence that non-financial earnings are on the verge of collapsing: Revenue growth is still strong, and guidance from management in several industries – notably infrastructure – is still positive.

Despite forecasts of only tepid GDP growth in the United States and evidence of sharply slowing growth in Europe and Japan, the outlook for earnings in the second half of this year is surprisingly good. The bottom-up consensus, as reported by Standard and Poor’s, is that earnings for the S&P 500 will grow by 9.2% in 3Q 2008 and by a whopping 62.5% in 4Q 2008 as comparisons become easier (the write-offs at financial institutions began in 3Q 2007). Overall, the consensus estimates are that earnings of the S&P 500 companies will be $84 billion in 2008, implying a 1.2% growth rate, and $109 billion in 2009, a 30% increase over 2009.

The S&P’s Recent Sharp Drop is Out of Line With Consensus Earnings Forecasts

The $109 billion earnings estimate looks too high to us — a figure of $90 to $95 billion would appear to be more realistic. Still, the move of earnings growth into positive territory in the second half of 2008 and continued positive earnings growth in 2009 does not seem to warrant the severe punishment the market has received in recent months: it was down 22.4% in mid-July from the peak reached last October 9, meeting the 20% decline standard that qualifies it for bear market status.

The market is currently pricing in operating earnings of $73 billion for 2009; this is the August 14, 2008 level of the S&P 500 of 1293 divided by the consensus forward P/E of 17.6x, or (1293/17.6x) = $73 billion. If earnings in 2009 wind up being between $90 billion and $95 billion, as we believe, the implication is that the S&P 500 ought to be trading between 1585 and 1670, even without P/E compression. In other words, the market appears to be markedly undervalued relative to our earnings forecasts.