How Long Can The Bulls Keep On Keepin' On?

Despite a number of relatively high profile headwinds that have confronted traders recently, stocks continue to be bought and the indices just keep “movin’ on up.” For those of you keeping score at home, the S&P 500 has finished higher 10 out of the last 12 weeks and has put up 21 plus signs in the last 25 weeks. To which, we have to say, impressive.

At least part of the explanation for the joyride to the upside has to do with the fact that the funerals for the economies of the U.S. and Europe were called off at the end of August. And then another part of the equation is the public’s decision to move back into the stock market this year. In short, it appears that 2011 is projected to be the year of the U.S. large cap stock and as such, money continues to pour into mutual funds. In fact, Lipper reported that $9.5 billion went into equity mutual funds last week alone. Impressive indeed.

Another part of the reason behind the steady move higher has to do with earnings and valuations. With the Q4 earnings season winding down, we can now look at the results from a macro view and the bottom line here is it was yet another good season.

According to Zacks, the year-over-year growth rate for the S&P 500 companies came in at +43.7%. Next, for every negative earnings surprise, there were 3.42 companies that provided an upside surprise. And finally, analysts continue to move up their future earnings estimates as the current estimate revisions ratio stands at 1.88. Of course, this will eventually lead to analysts “overshooting” to the upside. But for now at least, this is remains a good thing.

Looking at the EPS numbers for the week, 45 of the S&P 500 companies reported results with 31 coming in above expectations in terms of earnings per share and 50% beating their consensus revenue numbers. Through Friday, 414 of the S&P 500 companies have released earnings with 74% beating EPS estimates and 67% exceeding revenue targets.

Looking at the overall earnings season, StreetAccount cautions, “While still above historical trends, the season-to-date earnings beat rate remained below the 79% average over the prior three quarters. While dampened earnings momentum may be partly a function of the upward revisions heading into Q4 earnings season, it is also likely to fit into the worries surrounding margin sustainability. Recall that such concerns have largely revolved around surging raw materials and commodity input costs, though there have also been worries that productivity and cost-savings momentum may be waning.”

In English, this means that we need to keep an eye on raw material costs and whether or not those costs will start to be passed on to customers.

Since the earnings parade began with Alcoa’s report, the S&P has advanced +5.6%. Thus, it is hard to argue that the earnings season has not been a positive driver in the market’s advance.

S&P 500 earnings summary for the current earnings season:

• Total Reports this season: 414
  • Earnings Per Share “Beats”: 310 (74)%
  • Earnings Per Share “Misses”: 104 (26%)
  • Revenue “Beats”: 286 (67%)
  • Revenue “Misses”: 128 (33%)

Source: www.StreetAccount.com

How High is High?

With stocks simply movin’ on up seemingly each and every day, the question becomes one of, how high is high? Taking a quick peek at the P/E ratio, it would appear that the market still has some upside potential. And it is likely this analysis that supports many of the Street’s upbeat forecasts for calendar year 2011.

Zacks tells us that on a bottom-up basis (meaning that they add up the earnings for each individual company in the S&P 500), the S&P is projected to earn $96.04 this year. So, 1343.01 (the “P” – I.E. where the S&P’s closed on Friday) divided by $96.04 (the “E”) produces a P/E of 13.98. And while this cannot be considered a “cheap” valuation level, it is also far from what most would consider an “overvalued” level.

However, given what passes for earnings these days, it is important to note that P/E analysis can be more art than science. And it is for this reason that we prefer to look at GAAP earnings, which, according to Ned Davis Research are projected to be $92.80 for 2011. This puts the GAAP-based P/E at 14.47, which is well below the 85-year average of 17.00. (However, it is worth noting that the spike in the GAAP-based P/E to more than 125 in 2009 has skewed the average to the upside.)

While it may not be terribly meaningful from a statistical perspective, I like to look at the level of the stock market relative to the level of earnings (again, using GAAP-based or “real” earnings”). Thus, I’d like to point out that the current projection of $92.80 is the highest on record.

What does this mean? On a daily basis, the S&P 500 hit its all-time high in October of 2007 at 1565.15. GAAP-based earnings for the S&P 500 that year totaled 66.18. However, since things went to heck in a hand basket shortly after the S&P hit its high, we should probably look at the earnings from 2006, which is what the market was “working off of” (as well as the projections going forward) at the time it was making new highs – and before things started to slide off a cliff. Total GAAP-based EPS for 2006 were $81.51.

What’s the Point?

Cutting to the chase, I am likely not the only one recognizing that with S&P currently trading at 1343, it is currently14% below where it stood in October of 2007. And yet GAAP-based EPS is projected to be $92.80, which is 13.85% higher than 2006’s EPS levels (which at the time was a record high). Hmmm…

Before you jump to the conclusion that the S&P ought to be trading at 1781 (which is 13.85% higher than the October 2007 levels), we need to remember that the question of how much investors are willing to pay for earnings (i.e. the P/E ratio) is a constantly moving target. For example, in good times, traders will “pay up” for every $1 of EPS (think 1999, when GAAP-based EPS was only $48.17) while the multiple investors are willing to pay usually contracts dramatically during times when the outlook is questionable.

So, the question of the day, at least in terms of valuation, boils down to this: What is the outlook for earnings going forward? (Sustainability is the key at the present time.) And how much are investors willing to “bid” for those earnings?

The bottom line is that while the market has been moving steadily higher for six months now, valuations are not “expensive” at