Earnings Season: The Missing Piece of the Puzzle

by Wall Street Daily
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Submitted by Wall St. Daily as part of our contributors program.

There’s no doubt the market’s been on a tear, with the S&P 500 hitting its highest point in nearly five years just two weeks ago.

If you’ve been keeping a keen eye on the economy, though, it just doesn’t make sense.

Don’t worry. I still think we’re in a real recovery. But it’s been too sluggish to merit such a radical boost in the market.

Just look at unemployment or job growth rates to see what I mean…

Not to mention that real indicators of economic strength, like durable goods orders – measured by the ISM Manufacturing Index – don’t support such optimism, either.

Yet despite these signs that the market should be struggling, the forward multiples on the stock market continue to expand. The S&P 500 now commands a forward price-to-earnings ratio of 14, the highest since December.

So what’s the deal? Well, the imbalance we’re seeing comes down to two main factors…

#1: QE3. I’ve written before about the boost that more quantitative easing would give to the market, and how the periods around Fed announcements generate a huge percentage of market returns.

You should also know that all this cheap money QE provides ends up in stocks. And since stocks appreciate with any potential inflation in the future, their value will only increases down the road.

#2: Corporate earnings. Throughout this bull market, corporate earnings have continued to rise.

It’s important to note, though, that the rate of earnings growth has slightly outpaced revenue growth. This suggests that the impressive numbers are thanks (at least in part) to cost cutting. And this can only take earnings so far.

The situation in Europe threatens to put more pressure on earnings, too…

“The pockets of strength and growth that we’re seeing are coming from consumers at home in the United States,” according to Jim Russell at US Bank Wealth Management. However, “in the aggregate, Europe is a larger economy than the United States, and if it continues to be quasi-recessionary for an extended period of time, absolutely every company is going to feel the gravitational pull of that trend.”

So looking forward to this earnings season, which officially kicks off on October 9, some analysts are pessimistic about the results.

Of course, trying to predict total earnings is a fool’s game. But once companies start reporting next week, there are a few early filers that we’ll be watching to gauge what sort of effect Europe will have on our market.

For instance…

  • We’ll get some insight into the European financial markets when BlackRock, Inc (NYSE: BLK) reports earnings on October 17. You see, BlackRock isn’t really an investment bank, but an investment manager. So its earnings are mainly determined by assets under management. Since it derives 26% of its revenue from Europe, if the financial turmoil in Europe causes real trouble, we’ll see it in BlackRock’s results.
  • Next up, McDonald’s (NYSE: MCD) reports on October 19. The all-American burger maker actually derives 38% of its revenue from Europe. So this will be a great gauge for the economic health of European consumers. Keep in mind, though, earnings could be tainted by volatile food prices.
  • Finally, while we don’t expect much construction in Europe now, we’ll see just how bad the situation is when Caterpillar (NYSE: CAT) reports on October 24. Nearly 25% of Caterpillar’s sales from the last filing came from Europe. Let’s see how far that number falls this time around.

Bottom line: QE3 and strong corporate earnings might have bought us some time so far. But there’s no way of knowing how long the market can rally without solid economic fundamentals backing it up. If we don’t see another round of positive earnings this quarter, however, stocks could be on shakier ground sooner than we’d like.

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