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Do Earnings Argue for 1,200 on the S&P 500?

February 23, 2010


Whew, earnings season is always a hectic time. Analysts and money managers are just trying to keep up with their portfolios, companies and sectors, along with bigger-picture issues. Think of all the financial data and management conference calls combined with broader economic and global issues such as China’s growth, Greece’s debt, the Volker rule and healthcare reform.

Almost 90% of the S&P 500 companies have reported thus far, and as you know, results were generally better than expected, with operating improvements and cost cutting largely driving earnings. But with everything going on in the world, the market brushed off the positive-leaning results and is actually flat on the year.

The market, despite all its complexities and all the moving pieces of the macro and micro puzzle, is fairly straightforward in regards to performance and earnings. Over the medium to long term, if earnings go up, then the market (or company stock) will go up. Simple enough. Now, sometimes prices will go up or down further than earnings fundamentals would imply, and that’s how we make the most money, but the correlation is generally solid.

The chart shows how the S&P 500 Index closely tracks the operating earnings results of its 500 component companies.

S&P Operating Earnings (Blue) & Year-end S&P 500 Index Price (Green)

20100223tdIMG1.gif

View Larger Chart


It looks like 2009 aggregate S&P 500 earnings will be around $57, while average estimates for 2010 are $77.71. And for 2011, I conservatively estimate 5% growth to $81.61. The key questions are whether that $77 earnings estimate turns out to be accurate and, if so, whether the market will follow the earnings growth.

With the market essentially flat on the year, the market’s valuation is in line at about 14.3 times the 2010 estimate. As I have estimated for my Safe Haven readers, I believe the market will be up modestly this year, between 5-10% (to 1,200), which is in line with what the earnings estimates are suggesting.

Overall, earnings beat Wall Street estimates by 7%. Information technology, which is the largest industry in the S&P 500 (19% of the total), is providing the strongest earnings growth, with earnings up 25% above previous expectations.

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Consumer discretionary stocks (+14%) and industrials (+10%) also came in ahead of expectations. Note for the fourth quarter, it is better to look at the change in earnings estimates instead of the absolute earnings changes, because a year ago, earnings for many sectors were terrible (if not negative).

For the year, S&P 500 earnings estimates for 2010 have already been raised by 3%, but for the technology sector, estimates for 2010 have been raised close to 10%. So technology is providing the “leadership” in the market with fairly high expectations.

Let’s take a closer look at how various sectors performed. You can see from the chart below that sector performance varies. As noted, technology and materials sectors outperformed the S&P 500 over the past five years, but given their expensive valuation levels to start the year, have underperformed year to date.

20100223tdIMG_3.gif


Energy has been the best performer over five years, and I can make a solid case that energy should do well in 2010 and in 2011.

If we somehow manage to show steady economic growth throughout the year, that means companies expand and invest more and help bring unemployment down. That should help most sectors, including energy, industrials and technology.

Others such as telecom, utilities and healthcare stocks might not benefit as much from an improving economic picture, and have their own fundamental issues to deal with. Also, there is a lot of noise regarding the financial and healthcare sectors, making it tough to get overly excited about those areas.

Overall, with fourth-quarter 2009 earnings behind us, the market looks fairly priced. I believe 1,200 is still a good year-end estimate for the S&P 500. Of course, it doesn’t come close to matching last year’s high returns.

But it would be a reasonable and positive outcome that should be welcomed, especially given the number of potential risks that are lurking in the background.


Kent Lucas

Editor, Taipan's Safe Haven Investor

http://www.taipanpublishinggroup.com/

About the author:

Taipan Publishing Group
The Curious Investor is a stock investing blog written by Daniel Hung. The blog's aim is to provide both educational and informational articles on stock investing concepts, strategies, and potential targets. The author hopes that these articles will allow him and others to make informed and profitable investment decisions. Further, he invites readers to respond via comments or e-mail and participate in constructive discussion. Daniel Hung started The Curious Investor as a student at Columbia University and it blossomed into a passion for investing and finance he hopes to share with others. He now works for a private investment fund in New York, NY. For more articles and tutorials please visit: http://thecuriousinvestor.com

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