One of the arguments you hear alot these days from bulls is that stocks are cheap. At a P/E of 17 (based on 2006 earnings) for the S&P 500, stocks just aren’t all that risky, they say.
But this is very misleading. 2006 was a record year for corporate profits!!!! S&P profits have grown at a greater than 10% clip for 4 straight years now.
That can’t keep up and all signs suggest that this will be the year that it doesn’t. According to Thomson Financial (from this LA Times article by Tom Petruno), 1st quarter earnings for S&P 500 companies are expected to rise only 4.3% – the first time growth will be less than 10% in quite a long time.
In a recent Investment U, Mark Skousen pointed out that corporate profits are one of the best forecasters of recession and are usually one of the first indicators of trouble. He goes on to make two points:
The first thing to note is that real corporate profits started falling before the 2001-2002 recession, then anticipated a recovery in 2002.
Second, profits have been on a tear since 2002…. In the third quarter of 2006, profit growth was running at an annualized rate of 16%. Is this rate of profit sustainable? Probably not, and there’s already indications that the profit rate will settle into the high single digits this year.
To sum up: a 17 multiple on record earnings in a slowing growth environment is not cheap. Stocks are not cheap!!!
Update: I just came across a relevant article from Justin Lahart’s “Ahead of the Tape” column, which runs on the front page of the WSJ’s “Money and Investing” section everyday: “Profit Concerns Take Back Seat, For Time Being”, Wednesday March 14, 2007 (subscription required).
In it he points out that the market has been getting hit bad lately and investors aren’t even focused on the likely disappointing earnings news to come – it’s mostly been about problems with subprime mortgages:
….. first quarter earnings look set to post the slowest growth in five years.
In the past few weeks, companies have ratcheted down forecasts, and analysts have cut profit estimates sharply. At the start of the year, analysts expected first quarter earnings for companies in the S&P 500 would be 8.7% above year ago levels. Now, they expect an increase of just 4%, according to Thomson.
When earnings expectations fall so fast, it’s often a sign business is deteriorating. That can lead to a slew of additional profit warnings in the closing weeks of the quarter, when most such confessions take place.
Stocks have had a rough patch already ….. so it’s tempting to say the bad news is already in the market.
Problem is, investors have focused on the real estate mess, not earnings….. What happens if corporate warnings really kick in and investors notice?
In just 3 weeks 1st quarter earnings season will kick off. It could be a rude awakening for the bulls and their argument that stocks are cheap.