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Earnings Numbers the ‘Crash’ Pundits Are Ignoring

Spooked? Most investors are rattled following Tuesday’s 3% implosion, fueled largely by a sudden and unexpected dip in Consumer Confidence (more below), and an adjustment in China’s growth rate - as evidenced by a leading indicators index - for April (from 1.7% to 0.3%). The question is, is this cause for worry? Though the answer is ‘not really’, the answer is also irrelevant as long as the majority of other investors are troubled by the numbers. Their perception is rooted in fear though, which is short-lived. Here’s some bigger-picture perspective that’s rooted in data… which isn’t short-lived.

‘Overreaction’ Is An Understatement

We won’t rehash Tuesday’s trade; the bears easily won the day. Rather, we’ll explain the bet these sellers were making, even if they didn’t know they were making it (and they probably didn’t).

Like it or not, earnings have been getting better for the S&P 500’s stocks. That’s not the opinion of the underlying corporations - those are the calculations from Standard & Poor’s, which has no vested interest in pumping up performance measures. The chart of the S&P 500 Index versus the index’s EPS (were it a company share) illustrates where earnings were, are, and are expected to go.

Compelling chart, right? But weren’t earnings bolstered by an artificial stimulus, and won’t earnings slow down now that the stimulus is fading away and companies are left to fend for themselves? After all, the consumer isn’t much healthier than he was a year ago.

The answer to both questions - probably - is ‘yes’. And, if it were that black and white, we’d simply offer congratulations to Tuesday’s sellers and start packing up the secret bunker with food and ammo. There’s more to it than that though….. fortunately. There’s a ‘rest of the story’.

Will the earnings growth rate start to fade? Incredibly enough, Standard & Poor’s actually raised their 2010/2011 EPS outlook for the S&P 500 between May 19th and June 22nd. It wasn’t by much, but it clearly wasn’t a contraction in expected earnings either. Still, just for the sake of argument, let’s run the numbers for a couple of scenarios.

For 2010, Standard & Poor’s is looking for ‘S&P 500 Inc.’ to earn $81.73 per share. For 2011, the ‘company’ is expected to earn $94.84 per share.

Based on the 18th’s close of 1117.5, the S&P 500’s P/E ratio for 2010 was 13.67….. which is stunningly low. In fact, that’s almost as cheap as stocks have been (on an operating basis) since the late 80’s, before the tech bubble inflated (and then burst). Now, based on the closing price of 1041.2 from Tuesday the 29th, the 2010 operating P/E ratio is forecasted at 12.7, which is close to record lows for the modern era.

For 2011, the projected P/E as of the pre-tumble price of 1117.5 on the 18th was 11.8. As of Tuesday the 29th (post tumble), the 2011 P/E is now at 11.0.… which is lower than any P/E level we could find the market trading at for the last few decades.

See where this is going?

The question you have to ask yourself is just how badly will austerity, Greece, Spain, China, deflation, inflation, BP, new taxes, hurricanes, and a million other things impact earnings? It’s all a problem to be sure, but bear in mind the ‘best case’ and ‘worst case’ scenarios are rarely realized. Most of the time, reality turns out to be quite moderate…. squarely in the middle of the forecast spectrum.

Is a 30% hit on earnings for 2010 and 2011 realistic? If so, then as of Tuesday, the 2010 P/E still stands at a very palatable 18.2. For 2011, it’s an attractive 15.7…. cheap in comparison to any other timeframe since the late 80’s.

Even a 50% hit on expected earnings for 2010 and 2011 leaves the S&P 500 at a P/E of 25.4 for this year, and 21.9 for next year; we’ve been bullish on worse.

Basically, investors are pricing in financial Armageddon - a full-blown depression, and/or a repeat of 2008’s huge corporate losses (which were only huge because of the financial sector’s loan portfolio problems …. which aren’t likely to resurface the way they did then).

The fact is, there are greater forces working against a recession than for it. The strongest one is also the best one - profits are recovering, even if modestly, and even if the growth rate slows now (which it will). The government will step in (again) too, even if it comes down to printing cash to stave recession off. It’s not a desirable option, but it’s an option all the same.

Yet, with a stingy consumer and the looming possibility of higher taxes (to finance the deficit) though, stocks are still pricing in a worst-case scenario, and ignoring the fact that the consumer is at least off of life support. It may be ugly, but it’s not getting worse - and it’s definitely not 2008 again. The recession drum is pounding mostly because fear makes for great TV. None of those guys actually crunched the numbers though, even in a pessimistic light.

Make your bets as you see fit. We’ll remain in the long-term bullish camp, and yield to the bears in the short-term.

Consumer Confidence Dips

The chart says it all - the three month streak of stronger and stronger conference was broken in June when the Conference Board’s measure of consumer sentiment fell from 62.7 to 52.9.

On the other hand, like we said, the chart says it all.…no more, and no less.

The fact is, the consumer confidence TREND is still a rising one. It would be even if the comparable Michigan State Sentiment Index hadn’t moved upward to new multi-year highs in June. But, the fact that the MSI trend is indeed still pointed upward only underscores that reality.

As we’ve made clear on numerous occasions (including in our recently-updated ‘approach’ explanation), using one month’s worth of data to make one day’s worth of decision is a mistake. … even though that’s precisely what the market did Tuesday. The truth is, the confidence trend - which takes at least three months to fully materialize - is ten times more important than one month’s data, and in no way should drive knee-jerk decisions like we saw on Tuesday. It should drive multi-month decisions. Period.

To be fair, none of this is to say the economy can’t be headed into the gutter. It is to say that there’s no rational reason this data (or even China’s data from April) should prompt that assumption. No, Tuesday’s pullback largely materialized simply because assumptions were drawn without complete perspective. Sadly, those assumptions may continue to drive stocks lower for a while longer. In the end though, the market it always priced right.

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James Brumley is a freelance writer and registered investment advisor. He began his career as a broker with a major Wall Street firm, where fundamentals and long-term holding periods were core strategies. After that, he switched gears completely, becoming an analyst at a short-term trading newsletter that focused on technical analysis. He now manages client money using the best of both philosophies. His company, Bluegrass Portfolio Management, offers investors an opportunity to reap superior returns with minimized risk.