Earnings: Just Good Enough

Summer has brought an unremarkable season of second-quarter earnings releases. As of this date, the second-quarter profits figures are coming in slightly above Wall Street's consensus expectations. Still, the general slowdown in earnings growth from earlier in the cycle has some worried about future support for stock prices. This concern is premature. Though slowed earnings growth is clearly a fact of life, the rate of earnings advance should remain adequate to support further market advances, especially given still-attractive valuations.

As of this writing, a little less than 60% of the firms in the S&P 500®Index1have reported second-quarter earnings. Of these, almost three-quarters have beat, admittedly, conservative expectations. If normal patterns hold, investors will likely see second-quarter earnings about 4% above consensus expectations. Though these figures constitute only half the year, conservative assumptions suggest that the year as a whole might see operating earnings expand at a rate in the high single digits. This pace of growth is a far cry from the stupendous earning advances of almost 40% in 2010 and well into the high teens in 2011,2but it would constitute a modest uptick from last year's meager gains.

Looking out over the next four to six quarters, a slow earnings expansion is still in prospect. This reality is built into probable economic fundamentals. Though the economy will likely accelerate modestly during this time, and earnings with it, it is doubtful the real gross domestic product (GDP) will grow in excess of 2.5% on average. Inflation should average 1.5–2.0% at most. Combined, these basic trends suggest that nominal corporate revenues from domestic sources will expand on average at an annual rate of approximately 4%. Since a substantial part of the S&P 500 gains revenues from outside the country, the overall revenues growth figure could rise to about 5%.3To be sure, many overseas economies are slowing, and Europe remains in recession, but slowing in Asia and many parts of Latin America still means faster growth than in the domestic American economy. Meanwhile, recent dollar declines against the euro, if they hold, will enlarge the dollar accounting of any European revenue flows.

Earnings per share (EPS) should at least track this expected revenue expansion and could do slightly better. At the very least, profit margins should hold at the roughly 10% they have averaged for the past couple of years. They are, however, more likely to rise than fall. After all, margins have been higher, 11% in 2007, and with industry and business still operating at a relatively low 77.8% of capacity, there would seem to be ample operating leverage left to notch margins up a bit more. Even if margins stay flat, EPS should get an additional fillip from the ongoing high level of stock repurchases. At last count, companies were dedicating some 2.7% of their market capitalization each year to repurchase stock. Offset in part by the exercise of options and new stock issues, a conservative calculation suggests that the repurchases going forward could remove fully 1.0% of diluted shares outstanding, enlarging the per-share value of existing earnings and bringing the rate of per-share earnings expansion closer to 6% than the 5% anticipated for revenues growth.4

If equity prices merely track this earnings advance, the market will pay an attractive return. After all, 2% dividend yields would add to the 6% price gains to offer investors an 8% total return. And there remains a chance that price-to-earnings multiples could increase. To be sure, current multiples, at close to 16 times historical earnings, are about at historical averages,5but relative to bonds and cash, stocks still look cheap. Take, for example, the stock-to-bond yield spread valuation measure. Historically, the market multiple, expressed as an earnings yield, runs on average about two percentage points below the 10-year Treasury yield. Even after the recent upward adjustments in Treasury yields, it remains today almost four percentage points above the 10-year Treasury yield,6suggesting ample room for multiple expansions even if bond yields continue to rise. Similar positive comparisons for equities prevail with corporate bond and cash rates. But even if multiples simply hold, the EPS advance, plus the dividend yield, should provide stock investors with an attractive enough prospective return to justify a buy.

1The S&P 500®Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.

2Data from Standard & Poor's.




6Data from Bloomberg.

The opinions in the preceding economic commentary are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. This material is not intended to be relied upon as a forecast, research, or investment advice regarding a particular investment or the markets in general. Nor is it intended to predict or depict performance of any investment. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Consult a financial advisor on the strategy best for you.

© Lord Abbett


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