Acme earnings

28Aug06

Earnings both at the stock and index level are the bread and butter of much fundamental analysis. We have discussed some of the issues involved in using earnings-related statistics, like the P/E ratio, previously. With the market unable to make much headway, it begs the question: Are corporate earnings poised to run off a cliff, Wile E. Coyote-style?

From an earnings-based perspective one could argue that the market looks not altogether overvalued. One indicator we look at on a regular basis is the bottoms-up, Market Valuation Graph available over at Morningstar.com. This indicator has shown the equity markets as undervalued since June, and that was quite a change compared to the previous two and a half years.

The question is not really where earnings stand right now. The question is what happens to earnings going forward? Today’s earnings have been the beneficiary of record-high profit margins. Steven Greenhouse and David Leonhardt at the New York Times report on the inability of real wages to keep up with rising productivity levels. They discuss in-depth the political dimension of the wage issue, but one can see how this formula would lead to higher net corporate profits.

James Picerno at the Capital Spectator takes a look at this “golden era of profitability” and comes away with a degree of caution towards the stock market. With economic concerns on the rise and a once-ideal mix of corporate profitability waning stocks could be in for a “…stretch of mediocrity.”

John Hussman at Hussman Funds has been warning for some time that the reversal of high corporate profit margins could mean trouble for the stock market. This week Hussman is focusing on measures that show that the economy is rolling over. A weaker economy would logically lead to lower corporate earnings.

Barry Ritholtz at the Big Picture thinks we should not be focusing solely on the seemingly benign overall earnings numbers. If we take a look at the composition of those earnings we will see weakness masked by the soaring earnings in the resource sector and high levels of stock buybacks.

Speaking of stock buybacks, James Wiandt at IndexUniverse.com reviews an S&P study on the effect of stock buybacks on the market’s (imputed) dividend yield. There is little doubt that corporate America is now flush with cash. Some of that cash has gone towards stock buybacks. Buybacks are a bit of Rohrschach inkblot test with observers taking away their preferred conclusions. We would rank buybacks below stock dividends, but their rapid pace is indicative of some latent buying.

The bottom line is that earnings matter. However getting a good read on market valuations using P/E ratios is clearly tricky. With some measure of economic softness in sight the question is to what degree corporate profit margins weaken, if at all? If you have the answer to that question please tell us, we are dying to know.

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