During the heated election battle between Bill Clinton and George Bush in 1992, Mr. Clinton and his supporters got a lot of mileage out of the slogan: "It's the economy, stupid" — the point being that the economy was the key to most of the country's problems. (Mr. Bush lost the election, and laid much of the blame on Fed chairman Alan Greenspan's failure to steer the economy out of recession.) When it comes to today's stock-market problems, the slogan could be: "It's the earnings, stupid."
Plenty of observers have bemoaned the fact that the market is out of sync with the economy — since the economy seems to be doing not too badly, apart from a few bumps and jitters, and in particular the consumer is still buying houses and cars like there's no tomorrow. Meanwhile, the markets have flirted with a few rallies, but overall have headed down to four- and five- and six-year lows. Time and again analysts argue that stocks are undervalued, and yet the major market indexes remain in the tank.
The problem is that stocks don't look all that cheap based on earnings over the last 12 months — the Standard & Poor's 500 index is trading at about 30 times "trailing" earnings, which is fairly expensive on a historical basis. The bulls argue that multiples always look high at the end of a downturn, because profits have been depressed by the slow economy. If you use "normalized" earnings, they say, stocks look undervalued. That argument, of course, depends on your definition of "normal."
As recently as July, for example, most analysts thought the third quarter was going to produce fairly healthy profit growth — they were looking for about 16-per-cent growth for the S&P 500, which made stocks look quite attractive (three months earlier, the average growth estimate was 20 per cent). By Sept. 1, the target was 11.5 per cent. And now? Thomson Financial/First Call says the average estimate is about 7 per cent.
According to First Call, negative earnings revisions — where companies have cut their forecast for the quarter — outnumber the positive three to one. For every Dell Computer, which said Tuesday its profit will be at the upper end of forecasts, there are companies like Philip Morris and General Electric, which have both warned they will underperform estimates. On Wednesday, Dow Chemical joined the estimate-cut crowd.
It's not just the surprise earnings warnings from companies such as Electronic Data Systems — which said third-quarter results will be 80 per cent below expectations — that have the market spooked. It's the sheer volume of restatements, one that isn't confined to a particular sector, but has affected companies as diverse as General Electric, which makes everything from heart monitors to light bulbs, consumer products maker Philip Morris, appliance maker Maytag and steel pipe-maker Ipsco.
Could it get worse? Sure. "We're only half way through the peak period of third-quarter pre-announcement season," Chuck Hill told CBSMarketwatch on Monday. "We've still got some bad news to come." When reporting begins, he says, there will be some good news "in that we'll beat those downward-revised final estimates, but the worry is that it will probably be a repeat of the second-quarter reporting season, in that the numbers will beat the final estimates, but the comments accompanying them about the upcoming quarter will be negative enough to offset that."
Mr. Hill said First Call expected to see earnings revisions in the technology and capital-spending sectors, "but the breadth and depth of the warnings outside those two sectors has been somewhat of a surprise here in the third quarter and that's an ominous sign." The reality is that "we're not going to see any meaningful upturn in the capital spending sectors till sometime next year. Now the worry is, is the consumer spending going to hold up enough that we don't slide into a double dip."
According to Merrill Lynch economist David Rosenberg: "We are probably going to have to relive another ugly confession season when Q4 rolls around because the consensus for Q4 is still wildly optimistic," calling for 20 per cent growth. Next year, meanwhile, analysts are looking for 18 per cent growth, "and how that is going to be achieved with nominal GDP growth barely more than 5 per cent, and the well running dry from the post-recession productivity-led margin expansion, is a legitimate question."
The reality is that until some of those negative revisions start to turn into positive ones, the market is going to have a hard time getting too excited about how "cheap" everything is.
E-mail Mathew Ingram at mingram@globeandmail.ca
Look for exclusive Mathew Ingram commentary at GlobeInvestorGold
© The Globe and Mail
Only GlobeinvestorGOLD combines the strength of powerful investing tools with the insight of The Globe and Mail.
Discover a wealth of investment information and and exclusive features.
