The Three-week Countdown to Stock Market’s 2011 Has Begun

Tuesday, August 17, 2010

Stock analysts and investment managers are preparing for the post-Labor Day move to 2011. They know the way to earn superior returns is to anticipate well, and that means not waiting until New Year’s Day. This move to the next year, like last year’s, is especially challenging because neither the economy nor the stock market are back to “normal.”

We can get a glimpse of what this analysis will bring by looking at what has been happening to estimated earnings following the latest earnings reports.

First, a summary of some key points

Most earnings reports are in and, on balance, were good. A large majority exceeded expectations, although there have been three mood-dampeners:

  1. Revenue growth often lagged behind earnings growth. Some of the disappointment, though, is likely due to over-expectation. Economic growth has not returned to normal, so it is unreasonable to expect that most companies can experience normal sales growth.
  2. Company comments and outlook statements often contained uncertain or slower growth projections. Here, too, disappointment is probably because some investors were expecting optimistic forecasts.
  3. Deflation scare headlines. As I wrote in “Deflation – How It Can Exist Even As the Economy Recovers” (August 13), a study of business cycles provides a good understanding of what is going on, and it’s not all bad.

In summary, the recovery continues, albeit not in a straight line. Perhaps the most frustrating characteristic of this period is the continuing prevalence of uncertainty. Investors oftentimes expect earnings growth to be accompanied by agreement on the economy’s direction. So this period continues to mystify and worry – keeping those investors underweighted in stocks.

Now let’s turn from macroeconomic forecasts to what’s happening to estimated company earnings.

Earnings forecasts up nicely for 2010 and somewhat for 2011

The graph below shows an interesting development. The projected growth rate of the 2011 Dow Jones Industrial Average (DJIA) earnings compared to 2010 fell from 15% to 12.7%. However, it was not because 2011 estimated earnings decreased. Rather, 2010 earnings estimates increased 2.7%, exceeding the 0.2% for 2011 projected earnings.

Stock market, up over 26% from July 2009, carries same valuation

The next graph shows those earnings estimates in relation to the stock market. Last July, the DJIA carried the valuation of 11.1 times 2010 earnings. Since that time, it has risen 26% (excluding dividends) as 2010 earnings estimates have risen almost 13% and 2011 earnings estimates are anticipated to grow another 13%. The end result? The DJIA sells at 11 times 2011 earnings, virtually the same as 13 months ago. Why? Likely, it’s because uncertainty is still with us, including some big, scary doomsday forecasts. Certainly, there has been no move into stocks by investors to change these valuations. Rather, the market has been pulled upward by the earnings growth.

So, what do we do now?

Feel fortunate – especially if you are regularly investing in the stock market. Many in the investment industry have joked about the following scenario, never thinking that it could actually happen:

“Hope for a terrible stock market during your working (and investing) years. You want things to look awful, making prices low and valuations attractive. Then, just when you retire, hope that investor fear disappears and optimism blooms. That situation will make you more money than any other scenario.”

So… Even if you are already retired and fretting about stock investing, don’t stay away. The stock market’s 26% rise over the past year is not pie in the sky. It is a reflection of reality. At this time next year, if the estimates hold and 2012 shows a similar projected growth rate, the stock market could be up 13% (plus dividends) without any increase in valuation. If, on the other hand, the business cycle is viewed as nearing normal by then, there could be a significant added gain as investors decide that stocks are still a good investment, after all, and buy.

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