While earnings are largely trumping expectations, inflation fears abound as the Fed raises interest rates. Growth in the economy as a whole remains stagnant. How can that be? How can we have rising inflation and slowing growth?
Journalist and all-around economic bad-ass Steve Liesman (listen to him talk to the guest analysts on CNBC sometime and see if you can keep up) puts it all in perspective in today's WSJ (also posted as a comment for the non-subscribers, shame on you).
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What We Can Learn About Gap
Between Earnings, Stock Prices
April 22, 2005
Steve Liesman
You'd think the stock market was convinced we were about to start a new war, or that some other calamity was imminent.
Not since the eve of war with Iraq has there been such a wide gap between earnings and stock prices. With the recent market selloff -- even counting Thursday's stock market rally -- the forward price-earnings ratio of the S&P has shrunk to 15.21, just a bit above the 14.72 hit on Oct. 20, 2002, according to Thomson Financial.
I'm no raging bull, and I enjoy a big fat bear story just like any financial journalist. (Both good news and bad news are good for my business.) But this is getting a little whacky. "There's a huge disconnect between the marketplace and the value of the companies and the earnings that are coming out," David Dropsey, research analyst at Thomson Financial, told me this week.
Let's take a look at the running total of profits and forecasts that Mr. Dropsey puts together every day during earnings season.
We went into the quarter with the consensus estimate calling for S&P 500 earnings growth of 7%. (Please see my article from Feb. 18). By April 1, that number had sheepishly risen to 8.2%.
Where are we now? Try 11.9% with about 40% of the S&P reporting.
(Be forewarned: Thomson and most other Wall Street firms talk about operating earnings, a non-standard, non-official accounting method that excludes certain write-offs, or other expenses or gains that companies claim are not central to their operations. This is a debatable proposition and it's generally far better for investors to look at earnings reported under Generally Accepted Accounted Principles and compare them with operating earnings to see if the exclusions make sense. However, there are, as far as I know, no running analyst estimates of GAAP earnings. So, the extent to which profits beat or miss expectations -- that is, the extent to which markets may be correctly or incorrectly priced relative to earnings -- can only be measured by using the consensus operating-earnings estimates.)
With that said, there's every chance that the 11.9% first-quarter earnings gains could go higher. The reason: financials. They represent 29% of the S&P 500 market capitalization, and so far their earnings are up 7% compared with a year ago. The estimate had been for a 1% gain. But only half the financials have reported. If the rest of the financials do as well, first-quarter results will "continue to ramp up at an accelerated rate," Mr. Dropsey says.
Among the reasons for the gains: Banks are lending more and the mergers-and-acquisitions and IPO activity flow nicely to their bottom lines.
There's more potentially good news on earnings, including forecasts for the third and fourth quarters, but we need to pause now to look at what has spooked the markets so severely.
The Fed's Beige Book this week gave investors an overload of contradictory information. Sure, the overall economy was said to be expanding, but growth was characterized in a more cautious tone than a month earlier.
The Beige Book said, "…[A]ll twelve Federal Reserve Districts indicate that business activity continued to expand … Kansas City and San Francisco noted solid growth, Chicago and Dallas characterized growth as moderate, and Atlanta reported a robust pace. By contrast, while citing positive growth, New York and Cleveland mentioned uneven progress across sectors."
While more than half of the districts said that retail activity was up, the remainder used words like subdued, deteriorated or disappointing.
The market could process slower growth if it hadn't been forced to download depressing details on inflation: "Price pressures have intensified in a number of Districts, and most report that high or rising energy prices are a concern across sectors."
This, of course, causes a brain short-circuit. How can we have rising inflation and slowing or uneven growth? The brain grasps for something to hold onto and settles on the only word that comes to mind: stagflation.
Mind you, we are miles from what I would call real stagflation, which is flat or negative growth and rising prices. As Janet Yellen, president of the San Francisco Federal Reserve Bank told me this week, stagflation is on her radar screen, but "I would not overblow the parallels between the 70s and now. What we are seeing is something far more limited. Inflation expectations remain longer-term very well contained. Wage and salary growth and compensation overall is well contained. Productivity growth remains extremely solid. I think the fundamentals on inflation going forward are excellent."
What most economists see right now is slower growth that still remains in a range of 3.25% to 3.75%, which is above long-term trend. Even with higher inflation, that would hardly fit the description of stagflation.
Ms. Yellen acknowledged the soft-patch of growth we hit in March (see last week's column), but suggested higher oil prices had a similar impact last summer and the economy waved it off. She added that while higher oil prices could damp growth, they were as much a sign of solid global activity, suggesting that she favored further hikes in the Federal Reserve's overnight lending rate in the face of higher energy prices.
That brings us back to our earnings forecasts. One of the more remarkable aspects of first-quarter earnings is that companies are making money despite high oil prices. Take out energy, and the 11.9% S&P gain so far in the first quarter shrinks only to 8.9%, or just a little less than the twice what the estimate was in April.
What's more, estimates for the third and fourth quarters are solidly in the double-digits whether you include energy or not. The consensus calls for 16% earnings growth for the S&P 500 in the third quarter, up from 14.3% on April 1, and for 12.2% growth in the fourth quarter. Those are solid numbers and don't suggest either an overall economic or profits slowdown.
The big caveat to this is that the economy doesn't end up responding evenly to high oil prices. That is, it rolls along for a while amid these higher prices, going through these ups and downs, and finally reaches a tipping point that causes a recession.
That's one possibility and the likelihood can't be known. But here's another possibility: The last time the P/E ratio on the S&P was this low, (remember, back in October 2002) the S&P 500 Index a year later was 30% higher.
Take that past-performance data for exactly what you think it's worth.
Great article. He seems to be echoing the thoughts of the gentleman you posted about a week ago.
I think it is really interesting to see how much an impact financial institutions have. I think one area of caution concerning these is that it is cited above that financials are doing well because of increased lending. In my opinion, this is going to catch up to people. When you look at a savings rate of only 2% on average in the US, can an individual sutain that kind of lending?
I guess we'll have to see.
I'll post an article from the economist about this very problem in the US.
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