The Stock Market's Earnings Problem

Posted by: Ben Steverman on May 12, 2009

Stock investors are sitting on hefty gains from the past two months, when the S&P 500 index has regained 33% of its value.

But there are troubling signs the rally might not be sustainable.

Ed Yardeni of Yardeni Research summarized the problem in a note today:

[…] a bull market needs earnings to keep going. I think they are coming soon, but they aren’t here just yet. The bad news is that despite Q1’s positive earnings surprise, industry analysts continued to cut their estimates for the remaining three quarters of 2009. Their 2010 estimate is also still falling.

Last week, analysts’ estimates for S&P 500 earnings in 2009 and 2010 fell to new lows for this recession. Yardeni added:

I am especially concerned about the ongoing weakness in forward earnings because these data tend to be excellent leading economic indicators and predictors of the earnings outlook over the next 12 months. To keep the stock market rally, these need to start confirming the other data showing that an economic recovery is coming soon.

I think there are essentially three different ways to interpret the current stock market rally:

1. This is a false dawn. Investors are expecting a recovery in the second half of 2009, and they’ll be very disappointed when it doesn’t arrive. Unemployment is heading higher and could send the economy into another tailspin. So might financial shocks from the rest of the world. Stocks could easily return to their March lows, or fall below them.

2. This was a relief rally. Investors have decided the world isn’t headed for a second Great Depression after all. To maintain these gains, the economy and earnings don’t need to rebound strongly. They must merely tread water for a while. By stabilizing, they prevent a re-testing of the March lows but don’t necessarily guarantee future gains.

3. The economy has already begun to stabilize and a recovery for the economy and earnings are inevitable. This rally has just begun.

I don’t claim to know which scenario is correct, and, in these crazy times, I’d be suspicious of anyone who does.

Reader Comments

Ryno

May 13, 2009 4:26 PM

The stock market isn't based on earnings, it anticipates earnings and value. Most people know this and I would expect a columnist for Business Week would know this.

This column gives the reader absolutely no useful information.

Frank MacGill

May 14, 2009 11:50 AM

Ryno, the article is about Ed Yardeni's statement about forward estimates. He says the forward estimates are too weak to sustain a rally. Ben Steverman then adds that he doesn't know what will happen next. You are too harsh when you say this column gives the reader absolutely no useful information. But not by much.

So, Ryno, you sound pretty smart. Do you know what will happen next?

jimh

May 14, 2009 2:31 PM

Exactly Frank. While the market does operate off future expectations they are also based on near future, not years out. Typically, it has been suggested that the market looks forward and acts off expectations roughly 6 months or so in advance of current news. This is why it is typical in after action analysis to see that the market bottoms six months prior to actual conditions meriting any turnaround.

Considering the savings rate is high now due to bubbles popped and people realizing they have no equity/savings are now doing what should have been done all along. The US Economy up to now has been fueled by consumer spending for 2/3 of the total pie. Now that savings are from less than one percent to over five percent I fail to see how this thing gets back on track let alone having companies report profits at a pace that they will support a rising stock price valuation.

Ron

May 20, 2009 5:10 PM

I agree, sorry Ryno (three strikes). The way the market anticipates earnings (you are correct there) is by listening to the companies' estimated earnings, which as stated above, don't stack up yet. For what its worth, in my opinion, I get the feeling the answer will be between 1 and 2. We're not heading for the Great Depression, but the financial shocks will continue from around the world, and the recovery may be a little way off yet. We may retest March lows, or we may go down to a sensible new 'higher low', but I doubt new lows. But as Ben says - 'these are crazy times' - anything can happen!

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About

Bloomberg Businessweek’s Ben Steverman focuses on the latest moves in financial markets and emerging trends in stocks, bonds, and funds, always with an eye toward giving readers a better understanding of the sometimes confusing and often chaotic world of money. Standard & Poor’s senior index analyst Howard Silverblatt will also provide his take on companies’ finances and the markets. Voted one of the “Top 100 Finance Blogs” in 2007.

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