4 Reasons Not to Worry About Earnings

Since March 9, stock prices have surged -- and so have price-earnings ratios. While Standard & Poor’s 500-stock index has soared more than 60%, earnings have risen more modestly. Third-quarter profits are expected to increase only about 10% from the previous quarter; consequently, average P/Es have nearly doubled, from 14 at the market low to 27 as of October 16, based on profits for the four quarters that ended September 30. No wonder many investors are experiencing vertigo.

Here are four reasons why lethargic earnings and high P/Es shouldn’t bother you.

Earnings come later. The stock market discounts future events. The market usually does so correctly, although sometimes it’s wrong. Since 1938, corporate reports have turned up an average of eight months after a bear market ends. Companies, of course, report earnings for activity that has already taken place. That means the sales most companies make today won’t be reported to the public until early next year.

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Sometimes much later. Earnings can lag even further behind the stock market. The three-month 1990 bear market drew to a close in October of that year. But earnings didn’t begin to rise until 15 months later. (It took even longer for the unemployment rate to abate, prompting presidential candidate Bill Clinton’s campaign to adopt the mantra, “It’s the economy, stupid.”)

That bear market is instructive because it was the last one that stemmed, in part, from a financial crisis. That time, it was savings and loans that went bust en masse. It usually takes more time to recover from recessions sparked by financial crises than it does to recover from garden-variety recessions, which normally occur after the Federal Reserve Board starts raising interest rates to combat inflation.

The latest recession -- which probably ended in the third quarter -- was the longest since the Great Depression. It only makes sense that recovering from it will take longer than usual. “This was the longest recession in 75 years,” says Jim Stack, a money manager in Whitefish, Mont., who is also editor of the InvesTech Market Analyst newsletter. “I have no doubt that the recovery isn’t going to be as strong as the recoveries after the previous two recessions.”

Direction is everything. The market looks closely at how a company’s earnings per share compare with those of the previous quarter, the same quarter a year earlier and analyst estimates. Traders pay far less attention to the overall P/E of the market, or even to that of a specific company.

That odd phenomenon should work to the benefit of the bulls next quarter. The fourth quarter of last year, during which the world teetered on the brink of financial collapse, was a disaster for earnings. In the aggregate, companies in the S&P 500 lost 9 cents a share during that terrifying quarter -- the first time they had lost money since at least 1935, which is as far back as S&P earnings records go.

The last quarter of this year will be measured against the dismal performance of the same period last year. Yes, holiday sales are likely to be bleak again, and the unemployment rate probably won’t drop until late next year. But earnings will likely look terrific compared with those of a year ago and compared with the third-quarter figures. “That comparison makes all the difference at inflexion points in the economy,” says Jim Floyd, senior analyst at the Leuthold Group, a Minneapolis-based stock research firm.

Floyd thinks the expectations game also will work in favor of stocks during the fourth quarter. Companies typically try to guide analysts to estimate lower earnings than the firms actually produce. Stocks pop when earnings beat analyst estimates. “There will be a lot of positive earnings surprises in the fourth quarter,” Floyd predicts.

The market never stays at fair value. The average P/E for the stock market since 1928 is 16, according to InvesTech. Occasionally, the market actually trades at that point. But for years -- sometimes decades -- the market sells for nowhere near fair value. Market P/Es in the late 1990s soared into the mid 20s and stayed there for about five years.

You can make a case for investing in the stock market only when it’s trading at or below its long-term average P/E, but you’ll leave a lot of money on the table. Interest rates, the level of inflation, and the economy’s health, among other factors, also play key roles in the stock market’s returns. A better way to invest, I think, is to hunt for good values in the stock market, and keep your percentage of stocks fairly constant -- unless valuations become clearly excessive.

Stack, one of the few strategists who called both the start of the bear market and the beginning of the bull market, puts it this way: “Earnings aren’t going to tell us where stocks are going. Stock prices will tell us where earnings will be a year from now.”

At present, I’m partial to big-company stocks. A good way to play the continuation of the stock market’s rally with big caps is through Harbor Capital Appreciation (symbol HACAX). If you simply want to track a large-cap index, consider Vanguard Large Cap ETF (VV), an exchange-traded fund.

Steven T. Goldberg (bio) is an investment adviser.