S&P 500 Earnings Growth Not
Supportive of Stock Market Rally

recessionAs the stock market continues its climb, reports in the popular media have suddenly appeared claiming that stocks are cheap.

I have written in these pages recently about the most popular measure used to evaluate the markets: the price/earnings (P/E) ratio takes the current market price per share of a company or index, and divides it by the earnings per share of that company/index.

Historically, a P/E ratio under 10-to-1 is considered undervalued and a good time to invest, with the thesis being that corporate earnings have bottomed. When the P/E range is 10:1 to 17:1, the companies/indices are considered fair value; 18:1 to 25:1 they’re considered overvalued; with anything above 25:1 considered a bubble (the S&P 500 was way above 25 during the tech bubble of the late 1990s).

Currently, the S&P 500 is trading at a P/E ratio of roughly 14:1 times. This is considered relatively fairly valued to cheap, which is being used as an argument by the popular media and some analysts to buy stocks.

A closer look reveals that the double-digit corporate earnings growth that has occurred over the last two years in the S&P 500 has come to an end with the latest quarterly results, those of the fourth quarter of 2011. Although only about 72% of all firms in the S&P 500 have reported to date, the corporate earnings growth is tracking at roughly 7.5% for the final quarter of 2011.

Over the last two years, many companies have cut their expenses to achieve higher earnings growth. People were laid off and production cut back while better efficiency was achieved. This explains the double-digit rise in corporate earnings over the last two years. However, that chapter could be coming to a close, because there is only so much a company can cut and there are only so many ways to increase efficiency.

The trend for corporate earnings growth is on the downside and, should this continue, it would mean that companies within the S&P 500 are as efficient as can be. If that is the case, then the only way to achieve earnings growth is for companies to increase revenues.

Revenue growth was in the double digits in 2010, but has slowed each quarter of 2011 to the point where the third-quarter 2011 revenue increase, year-over-year, was 8.5% and fourth-quarter revenue increases, year-over-year—with 72% of firms reporting in the S&P 500—have managed to increase revenue only 6.7%.

The revenue trend is slowing as well. Many of the companies that have reported earnings to date in the S&P 500 have cut expectations for 2012.

If companies have cut expenses to the bone, then revenue growth is the only way to sustain the rally and corporate earnings. But with high unemployment still in existence, consumer real disposable income growth nonexistent and inflation rising, revenue growth may elude many S&P 500 companies this year. The above analysis of corporate earnings and revenue growth for public companies just provides more credence to my theory that we are simply in a bear market rally, not a real bull market built on an improving economy

or on improving corporate earnings.

Michael’s Personal Notes:

A bailout deal for Greece has finally been reached and it will be implemented this week. Basically, the bondholders of Greek debt submitted their bonds worth €177.2 billion and received €55.8 billion in new bonds back—a roughly 70% haircut for the bondholders.

Now that the agreement has been reached, the European Union has agreed to provide Greece with the next sum of bailout money, to the tune of €130 billion. However, this money will not be paid all at once. It will come in installment payments from the European Union. The first installment is this month, at €5.9 billion, while April’s payment will be €3.3 billion.

The European Union is providing this money in installments, because it wants to monitor Greece to ensure it meets its bond payment targets and implements austerity measures in its laws to meet the targets.

The oddity is that these targets set by the European Union are based on fantasy.

Greece has to further cut welfare payments, its defense budget, pharmaceutical spending, and restructure central and expenses at local governments in order to meet the European Union’s target. Of course, we all know what restructuring means: job cuts and cuts in wages.

Now the European Union is saying that if Greece follows its prescription, and cuts 5.5% of GDP further, it will meet its debt payment targets for 2013 and 2014. The European Union is basing its assumptions on Greece’s GDP being zero in 2013, and growing slightly in 2014.

Well, dear reader, let’s look at Greece’s GDP over the last few years:

2008 GDP: 0.2%

2009 GDP: -3.3%

2010: GDP -3.4%

2011: GDP -6.9%

So now Greece is expected to show flat GDP in 2013 and Greece’s economy will somehow grow again in 2014?

Let’s remember, dear reader, that in spite of these trials Greece is facing, it is part of a European Union that is in a worsening recession, which means that any hope Greece has of growing is further being held back by the recession in the European Union.

I suspect that, as economic numbers from Greece come in later in 2012, it will be obvious to everyone that Greece will not be able to make the bond payment targets set by the European Union in 2013 and 2014. Worse, the additional cuts demanded by the European Union will cause more protests in the streets, as the unemployment situation deteriorates further due to the new cuts.

The European Union crisis has not gone away, dear reader. It will start again very soon as the European Union has solved nothing with Greece. In the meantime, the stock market moves higher, seemingly unworried…

Where the Market Stands; Where it’s Headed:

Many factors are working against the stock market rally—but there’s one important one. The number of stock market advisors bullish on stocks has declined significantly, which bodes well for the stock market. As I have been saying all along, we are in a bear market rally that will bring stocks higher, luring investors back into stocks before the next phase of the bear market gets underway.

What He Said:

“Over the past few weeks, I’ve written about subprime lenders and how their demise will hurt the U.S. housing market, the economy, and the stock market. There’s no escaping the carnage headed our way, because the housing market and subprime business are falling apart. The worst of our problems, because of the easy money made available to borrowers, which fueled the housing boom that peaked in 2005, have yet to arrive.” Michael Lombardi in PROFIT CONFIDENTIAL, March 22, 2007. At the same time that Michael wrote this, former Fed Chief Alan Greenspan was quoted as saying “…the worst is over for the U.S. housing market and there will be no economic spillover effects from the poor housing market.”