Earnings Will Likely Be Good, But How Will The Market React?

I have been prepared for a market correction for a while now, but we have yet to get one. The rally off of the March lows has reached +61% and the momentum continues to be strong. Will it continue even as companies report their third quarter earnings?

Nobody can know for sure, but over the years we have often seen a "buy on the rumor, sell on the news" mentality on Wall Street, especially during earnings season. Stocks ramp up heading into reporting season, only to fall after the news of solid results actually comes out. A similar phenomenon could certainly happen this quarter and as a result I will be carefully watching both what the numbers are, but also how the market reacts to them.

If stocks sell off even after companies post in-line or slightly better than expected earnings, such market action could be the first sign that a long overdue correction in stock prices is on the horizon. In fact, we might already be seeing this. This morning Johnson and Johnson reported earnings seven cents ahead of estimates but the stock is trading down in premarket trading. Will that be the start of a trend, or simply an aberration? We will have to wait and see.

Evaluating Market Level With S&P 500 Having Reached My Fair Value Target

I have written here previously that my personal fair value target for the S&P 500 index was around 1,050. I got there by using an average P/E multiple of 14-15 and projecting a "normalized" earnings run rate for the index of around $70 annually. The index has now risen 60% from its March low and hit a level of 1,074 intra-day on Thursday, about 2% above my target. Naturally, the next question is "what now?"

First we need to reevaluate my initial assumptions to determine if they need to be revised. Current earnings estimates on the S&P 500 for 2009 are about $54, which is a 9% increase from 2008. Estimates going forward are significantly higher than that, at around $73 for 2010. Does my $70 still apply?

In my mind it does. The idea behind trying to determine "normalized" earnings is to eliminate the long tails of the distribution. Valuing stocks based on earnings during a recession ($50-$55) is not very helpful given that the economy grows during the vast majority of all time periods. Conversely, using the previous peak earnings level ($87) factors in a period of easy credit and dramatic leverage which surely boosted profits to unsustainable levels.

So, I would define "normalized" earnings as the level of corporate profits that we could expect in neither a recessionary environment (negative GDP growth), or a highly leveraged economy (say, 4-5% GDP growth). Put another way, what would earnings be if the economy was growing, but not very fast (say, by 2% per year). Something between $50 and $87 most likely, and the number I have been using is $70 for the S&P 500.

Interestingly, the consensus for 2010 is for moderate economic growth, positive but not at the pace we saw earlier this decade. Given that the current earnings estimate for next year is $73, I believe my $70 figure still makes sense, given what we know right now anyway.

Where does that put us in terms of the market? Well, in my mind we are trading pretty much at fair value, but it is helpful to look at both the more bearish case and the more bullish case to get an idea of what the risk-reward scenario looks like. Comparing your potential upside with the corresponding downside should make it easier for investors to gauge how they should be allocating their investment capital.

First, the bears will argue that earnings are being helped merely by cost cutting and that revenue growth will be non-existent because the economy will remain in a rut for a long time. They will contend that earnings in the $70 range for 2010 is overly optimistic and will cite the $54 figure for this year as a more reasonable expectation in the near term. Assign a 14-15 P/E (the median multiple throughout history) on those earnings and you get the S&P 500 index trading between 750 and 800, or 25-30% below current levels.

Next, we have the bulls on the other end of the spectrum. They believe that slow to moderate growth in 2010 is likely and S&P 500 earnings in the $70 to $75 range are reasonable expectations. They go further and argue that given how low interest rates and inflation are presently, P/E multiples should be slightly above average (the argument there being that low rates and low inflation make bonds less attractive and stocks more attractive, so equities will fetch a premium to historical average prices). They will assign a 16-17 P/E to $73 in earnings and argue that the S&P 500 should trade up to around 1,200 next year, giving the market another 10 to 15% of upside.

From this exercise we can determine the risk-reward using all of these arguments. Bulls say 10-15% upside, bears say 25-30% downside, and I come in somewhere in between at a flat market. Therefore, I am cautious here with the S&P 500 trading at 1,066 as I write this. To me, aggressively committing new money to equities at these levels comes with a fair amount of risk given that the best case scenario appears to only be another 10 or 15 percent. As a result, I am holding above average cash positions and being fairly defensive with fresh capital. There just aren't that many bargains left right now, so I am hoping the next correction changes that.

Speculative Trading Lends Credence To "Rally Losing Steam" Thesis

A disturbing recent trend has emerged in the U.S. equity market and many are pointing to it as a potential reason to worry that the massive market rally over the last six months may be running out of steam. Investment strategists are concerned that a recent rise in speculative trading activity is signaling that the market's dramatic ascent is getting a bit frothy.

This kind of trading is typically characterized by lots of smaller capitalization stocks seeing massive increases in trading volumes and dramatic price swings, often on little or no headlines warranting such trading activity. Indeed, in recent weeks we have seen a lot of wild swings in small cap biotechnology stocks as well as some financial services stocks that were previously left for dead.

For instance, shares of beleaguered insurance giant AIG (AIG) soared 27% on Thursday on six times normal volume. Rumors on internet message boards (not exactly a solid fundamental reason for a rally) which proved to be false were one of the catalysts for the dramatic move higher, which looked like a huge short squeeze.

Consider an interesting statistic cited by CNBC's Bob Pisani on the air yesterday. Trading volume on the New York Stock Exchange (NYSE) registered 6.55 billion shares on Thursday. Of that a whopping 29% (1.9 billion shares) came from just four stocks; AIG, Freddie Mac (FRE), Fannie Mae (FNM), and Citigroup (C). Overall trading volumes this summer have been fairly light anyway and the fact that such a huge percentage of the volume has been in these severely beaten down, very troubled companies should give us pause for concern.

While not nearly as exaggerated, speculative trading like this is very reminiscent of the dot com bubble in late 1999 when tiny companies would see huge volume and price spikes simply by issuing press releases announcing the launch of a web site showcasing their products.

I am not suggesting the market is in bubble territory here, even after a more than 50% rise in six months, but this kind of market action warrants a cautious stance. Irrational market action is not a healthy way for the equity market to create wealth.

Fundamental valuation analysis remains paramount for equity investors, so be sure not get sucked into highly speculative trading unless there is a strong, rational basis for such investments. Companies like AIG, Fannie, and Freddie remain severely impaired operationally and laden with debt.

As a result, potential buyers into rallies should tread carefully and be sure to do their homework.

Full Disclosure: No position in any of the companies mentioned at the time of writing, but positions may change at any time

Analyst Call on Baidu Shows Why Most Wall Street Research Calls Are Useless

There are several reasons I typically ignore Wall Street analyst calls. The most compelling is the fact that sell side recommendations over the long term have been shown to underperform the market with above average volatility. Those are lose-lose metrics for investors.

Such poor performance is largely attributable to analysts being backward looking when they make research calls, despite the fact that they are supposed to be analyzing the equity market, which is a forward looking mechanism. Too many times analysts will upgrade stocks after the firms report strong numbers and vice versa, which does nothing to add to investor returns relative to the benchmark index they are trying to beat. Successful investing requires insight into the future, not reaction to the past.

To illustrate this point, consider an upgrade from UBS analyst Wenlin Li on Monday. Li covers Baidu.com (BIDU), the internet search giant in China. Baidu reported second quarter earnings of $1.61 per share, above consensus estimates of $1.44.

Prior to the earnings report Li had a sell rating and $150 price target on Baidu, which was trading over $300 per share. That in itself appears to be a contrarian call, which would be commendable (wrong, but commendable nonetheless). After the strong report was released, despite only a small upside surprise, Li upgraded the stock to neutral and raised the price target to $380 per share, a stunning increase of 153 percent.

How does a single quarter's earnings beat of 12 percent explain a 153 percent increase in one's fair value estimate for a stock? It doesn't, not by a long shot. This is the epitome of a completely useless Wall Street research call.

To see how this analyst messed up so badly, we only need to look at the changes made to their BIDU assumptions. Li now estimates 2009 revenue at $658 million, up from $542 million, while 2010 and 2011 sales are revised upward by 33% and 38%, respectively. Gross profit as a percentage of sales estimates were also revised upward, by 60% this year, next year and 2011, and net profit was revised up by about 40% per year.

Remember, an analyst's sole job is to follow companies and estimate how much revenue they will bring in and what proportion of that will flow through to the bottom line. Without solid insight into these metrics ahead of time, analyst calls are of little use to investors, which unfortunately is the case more often than not on Wall Street.

Full Disclosure: No position in BIDU at the time of writing, but positions may change at any time

Recent Market Rally In Graphic Form

As we already know, the stock market moves based on how reality compares to investor expectations. The chart below, courtesy of Bespoke Investment Group, shows just how good earnings have been so far this reporting season.

Do Not Be Fooled, Earnings (Not Sales) Are What Truly Matter

The U.S. stock market has rallied six percent so far this week after second quarter earnings have thus far boosted investor confidence. The four large companies getting the most attention this week have all surpassed estimates (Goldman Sachs, Intel, Johnson and Johnson, and Yum Brands).

It is hard to paint these results with anything but a positive brush, but that has not stopped many commentators from trying to throw cold water on the initial set of earnings reports. Their core argument (which we hear all the time from the bears and really frustrates me) is that while earnings have been solid, sales have been uninspiring. "You can't cut your way to prosperity" they say, alluding to the fact that cost cuts are helping U.S. companies exceed consensus profit expectations.

I roll my eyes when I hear this logic because sales are pretty much irrelevant when valuing equities. Shareholders own a proportional claim on a company's future profits, not sales. Heck, if sales were all that mattered, the dot com bubble never would have burst and shareholders of pets.com would still be rich. The Internet bubble popped because selling dollar bills for ninety cents is not a sustainable business model. You might be able to rack up some serious sales growth that way, but the business will not survive.

Now, I do not disagree with the notion that sales have been lackluster. After all, we are in a recession so anything but weak sales would be a real surprise. Just remember that stock prices are based on earnings, not sales. As a result, if the companies I own can boost profits by cost cutting while the economy is in decline, that is fine by me. Once the recession ends, we will have plenty of time for sales growth to impress everyone.

Powerful Market Rally May Be Running Out of Steam

After a very surprising employment report this morning (payrolls declined ~350k versus expectations of ~525k), the market reacted well at first but sellers have emerged. The fact that the market is flat today tells me the rally is losing steam (normally that type of jobs report would mean 200 or 300 points on the Dow). We may be at a point now where slow economic improvement has been priced into stocks, and as a result, incoming data that supports that thesis may not give a huge jolt to equity prices going forward.

This is a perfect example of how the stock market discounts the future ahead of time. We have had an enormous move since early March (S&P 500 up 42% from 666 to 944) on expectations that the economy would begin to slowly improve. Now that it appears to be happening, the market is looking ahead at what might be next. The answer to that question is a lot less clear.

My personal fair value target for the S&P 500 remains 1,050 but I have been raising cash into this rally below that level because there are still risks to the economic recovery and I want to save some cash for the next market drop. Recovery has to be a foregone conclusion, in my view, for the 1,050 level to solely dictate my actions.

Not only that, but more and more strategists are looking for 1,000 on the S&P 500, whereas they weren't even mentioning it as a possibility a month or two ago. As a contrarian, that makes me think it is getting less likely we will reach that level in the short term.

"Buy and Hold" Doesn't Work If You Completely Ignore Valuation

The current bear market resulted in the first negative ten-year period for the U.S. stock market in a long time. This has prompted many people to declare that the investment strategy of buying and holding stocks for the long term ("buy and "hold" for short) is all of the sudden "dead" or no longer viable.

Personally, I find this death pronouncement a bit odd. Just because stocks went nowhere from 1999-2008 means that investing in stocks for ten years is flawed generally? Since when does one instance of something not working render the entire concept flawed? I don't think a 100 percent success rate is required for one to declare it a viable strategy.

The reason "buy and hold" became popular is because, over long periods of time, stock prices mimic corporate earnings, which have risen over business cycles since the beginning of our economy. Legendary fund manager Peter Lynch continually reminds people that it is no coincidence that over decades the gains in the U.S. stock market are practically identical to the gains in corporate earnings (stock ownership represents a proportional share in profits generated by the firm).

The key point here is that the relationship only holds over long periods of time. In any given year, there is virtually no correlation between earnings growth rates and equity market gains. That is why "buy and hold" is a widely accepted investment strategy. If you invest over the long term, the odds are extremely high that earnings and stock prices will rise, and do so at higher rates than other investment alternatives.

I bring this up today because a former CEO of Coca Cola was a guest host on CNBC this morning. He and the CNBC gang discussed the fact that shares of Coke are actually down over the last ten years (since this person left the CEO post), as the chart below shows.

The CNBC commentators were quick to point out that Coke's earnings have more than doubled over the past decade, but the stock has actually lost value. Does this example support the idea that "buy and hold" is a flawed strategy, or is there something else at work here?

The latter. Coke stock carried a P/E ratio above 50 back in the late 1990's, during the blue chip bull market. Even when earnings grow dramatically, if P/E ratios are in nose bleed territory, "buy and hold" may not work, as was the case with Coke.

As a result, "buy and hold" does not work blindly. If you dramatically overpay for a stock, there is a good chance that you won't make any money, even over an entire decade. From my perspective, this does not mean that "buy and hold" is dead (the long term relationship between earnings and stock prices is unchanged), it simply means that valuation is important in determining future stock price returns (statistics show it is the most important, in fact).

The takeaway from this discussion is that "buy and hold" investors are likely to do very well over the long term, as long as they don't grossly overpay for an asset. The U.S. stock market in the late 1990's was more expensive, on a valuation basis, than at any other time in its history. Buyers during that time can't be saved from their own poor decision of paying too much for a stock, even by a proven long term investment strategy. Unfortunately, most non-professional individual investors don't focus on valuation when picking stocks for their portfolios, and often pay the price as a result.

Full Disclosure: No position in Coca Cola at the time of writing, but positions may change at any time

After Huge Rally, Market Digests Earnings Season and Bank Capital Raises

With most first quarter earnings reports having already been released, along with bank stress test results, the action in the market has died down considerably. After a 40% rally, the S&P 500 has been consolidating between 875 (a key technical support level) and 930 (the recent high). Such backing and filling is a strong sign. One would expect a pause after such a huge move, and despite the fact that the banks are rushing to issue billion of dollars in new shares, the market is absorbing that new supply fairly well (the stocks are down from their highs but they seem to be building a base and fear has subsided).

As for earnings season, first quarter results largely exceeded reduced expectations. Bulls and bears will continue to debate whether beating those low estimates was a positive or not, but merely stopping the earnings decline would serve to put a floor on stock prices. If the rate of decline in both the economy and corporate profits can decelerate, we could very well see sideways market action for a while. With the S&P 500 up from 666 to nearly 900, that would be welcomed by most investors.

The recent rally has been predicated on the idea that Q4 2008 and Q1 2009 will turn out to be the worst quarters for the economy. If GDP can rise sequentially throughout the year, and turn positive on a year-over-year basis by the fourth quarter, corporate profits will likely have hit a bottom. This scenario is priced into equities, so we really need it to play out that way for the S&P to hold the 900 area in coming months.

There are still plenty of people who are negative on the economy and either don't think a rebound will occur later in 2009, or if it does, it will be short-lived and we will see even worse times in 2010. If that proves true, we could very well see a retest of the March lows, as the bears are expecting.

Where do I come down? I think there is a decent chance we do not see 666 on the S&P 500 again. By "decent" I mean, say, between 50% and 67%. The rest of 2009 could very well be rocky though, so we could certainly get a correction or two, especially after a 40% rally in the market. As a result, I am holding some cash (10-20% right now in many cases) in order to take advantage of any other leg down if we get it. That cash number will likely increase if the market rally continues and we approach my own fair value estimate (1000-1050 on the S&P).

In general, I think a solid path would be for the market to trade sideways for a while. Digesting the big move we have made, rather than simply seeing another large sell-off (which was the typical course over the last year or so) would send a signal that the worst may be behind us and we can slowly recover. I agree with many who believe an economic recovery will be neither particularly fast, nor violently strong, but simply muddling along with little or no GDP growth would go a long way to supporting stock prices at their current level and take the calls for 600 on the S&P off of the table.

Meredith Whitney Quitting Oppenheimer Helps Show Contrarian Indicators Still Work

As my clients know well, I am a contrarian when it comes to investing in the market. To me, buying a stock is no different than shopping for a new house, car, or wardrobe at the mall. You get your best deals when you are either buying things other people don't want (store sale racks, foreclosed properties), or buying things when other people aren't shopping for them (winter coats well into the season).

As a result of natural human behavior, many market participants use contrarian sentiment indicators to guide their investment strategy. Measures of investor bullishness and consumer confidence, for example, are proven contrarian indicators. Sometimes certain events can even mark emotional extremes.

Consider banking analyst Meredith Whitney's decision on February 18th to leave her sell side job at Oppenheimer to start her own firm. Prior to October 2007, few people even knew who Whitney was, but after she became one of the first analysts to point out a possible capital shortfall at Citigroup (C) she immediately became the face of the banking crisis (thanks to the financial media) and has been extremely bearish on the group ever since.

So, we have a relatively unknown banking analyst make a good call on a large bank stock, the media picks up on it and runs with the story for months, and less than 18 months later she has enough of a following to start her own firm. These kinds of events often mark extremes, in this case, the depths of the banking crisis. For an analyst who made her career by being unrelentingly bearish on banks, it stands to reason the banking sector would be struggling mightily around the time she quit her job to go out on her own. It makes sense to question whether negative sentiment would be peaking around that time.

Of course, I wouldn't have used this example if it didn't serve as a positive data point for the contrarian indicator thesis. We won't know for another year or two if Whitney quitting actually was a great contrarian indicator or not (it's too soon to call the bottom in the banks), but it took only 12 trading days for the bank stocks (and the market itself) to put in a fierce and dramatic bottom on March 6th. Since then the market has risen 36%. Financial stocks have fared even better, soaring 105%.

Another contrarian indicator I follow is the number of worried emails and phone calls I get from my clients about their investment portfolios. If I get a few clients expressing concern over a period of days, that signals to me that sentiment is extremely negative and a bottom may not be far off. This personal indicator of mine peaked on March 2nd, merely four days prior to the market's bottom.

All in all, contrarian indicators measuring sentiment among investors and other market participants can still be a very valuable tool when managing one's investments. I recommend keeping them in mind as you continue to follow the market and your portfolios.

Full Disclosure: No position in Citigroup at the time of writing, but positions may change at any time