Why You Need to Pay Attention to Earnings

What the estimates say about the market's future

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Tim MicKey

With earnings season officially underway, everyone will be watching to see if analysts’ expectations are being met or if future earnings will need to be adjusted for the rest of the year.

There are a lot of concerns this earnings season about the Gross Domestic Product (GDP) growth rate in China and about just how slow things will get in Europe. We should get the answers to both of these questions by watching the earnings of the large multinational corporations. These are the companies that will have the most to lose if the global economy begins to slow.

Not only will they likely face weaker demand for their products, but they will also likely face a strengthening dollar. The problem they have is that when converting their earnings to dollars, the stronger the dollar, the weaker the conversion. For this piece, I will concentrate on the expected earnings of the S&P 500 companies, which have historically derived about 50 percent of their earnings from overseas.

Before we get into the first quarter earnings season, a quick review of the fourth quarter and the rest of 2011 is worthwhile. January 9, 2012 to February 21, 2012 is when most companies reported their fourth quarter 2011 results. During this time period, we saw a 6.36 percent increase in the S&P 500 index. The percentage of companies that beat their estimates ended up at 60.4 percent, which is just below the 62 percent average from the last 10 years.

To help put the average of 62 percent into perspective, one should note that the highest percentage of companies beating estimates came in around 70 percent back in the first quarter of 2004, as well as the third quarter of 2005. The lowest percentage of companies beating estimates was around 50 percent in the first quarter of 2000.

Something else worth noting is the percentage of companies that beat top line revenue expectations, which came in at 56.7 percent—a three year low (compared to a ten-year average of 62 percent). For the year 2011, the combined earnings of the S&P 500 came in at $96.44. The S&P 500 ended the year at 1,277.03, leaving the index with a price-to-earnings ratio (P/E) of 13.24. A P/E of 13.24 is on the low side of historic averages, given that the P/Es of the S&P 500 from 1988 to today range from a high of 29.44 in the fourth quarter of 2001 to a low of 11.51 in the fourth quarter of 1988. If you eliminate the extremes, you come away with average P/Es which fall between 13x and 16x earnings for the index.

Estimated earnings for 2012 and 2013 are important to look at, but they could vary significantly from current projections for various reasons that no one can predict with any degree of certainty. They can, however, be looked at to help determine if the markets seem overvalued or undervalued based on historic averages. For example, the combined earnings estimate of the S&P 500 for 2012 is currently around $104.00, which is an 8.8 percent increase over 2011.

The estimates for 2013 come in around $118.00, which is a more than 13 percent increase over 2012. If you were to assume a normal P/E range of between 13x and 16x earnings, the S&P 500 index would trade between 1,352 and 1,664 during 2012. Assuming the 2013 projections of $118.00 would leave the index trading somewhere between 1,534 and 1,880.

Getting back to the current earnings season, the expectations have been fairly low. Many analysts have brought expectations down over the last few months to a point that may allow many of the companies to exceed these projections. More recently, we have seen better economic reports coming out of the U.S. (with the exception of the jobs report last Friday) that have inspired analysts to make adjustments.

The reports have caused an increase in the earnings expectations of 539 companies in the S&P 1500 over the past four weeks and a decrease in the estimates for 426 companies. This works out to a net of 113, or 7.5 percent of the companies in the index. This is a very positive sign for the markets going into earnings season. In fact, we have had a positive earnings revision ratio for the past four weeks. This is especially encouraging because it comes at a time when companies and analysts tend to be more pessimistic.

So where does that leave us? It leaves us watching and waiting to see how well or how poorly the companies’ earnings turn out for the quarter. It also leaves us waiting to see what the expectations are for the future. Remember, the direction of a company’s stock price is more a reflection of the company’s future, not the past.

The markets are currently trading well within normal P/E trading ranges and have significant upside potential if the current estimates turn out to be fairly accurate. Earnings and earnings estimates are important enough to pay attention to, but they do not take the place of having a solid financial plan. Understanding your risk tolerance and having a long-term strategy is far more important.

Timothy S. MicKey, CFP®, is a managing director and cofounder of Monument Wealth Management in Alexandria, Va., a full-service investment and wealth management firm. Monument Wealth Management is backed by LPL Financial, an independent broker-dealer and Registered Investment Advisor, member FINRA/SIPC. Monument Wealth Management has been featured in several national media sources over the past several years. Follow Tim and Monument Wealth Management on their blog Off The Wall, on Twitter at @MonumentWealth and @TimothySMickey, and on their Facebook page.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for individuals. To determine which investment is appropriate, please consult your financial advisor prior to investing. All performance references are historical and are not a guarantee of future results.