EmailFourth quarter earnings reports indicate that the underlying trend in earnings growth is slowing. Concern about the earnings outlook for 2012 may restrain the recent bullish sentiment in the months ahead. The relative value argument in favor of stocks, however, remains strong.
2011 Earnings by Quarter
Through Friday, 37% of the S&P 500 companies had reported earnings for the fourth quarter of 2011. These reported earnings, combined with estimates for the remaining 63% of companies, track to an 8% gain in aggregate earnings for the S&P 500 compared to the fourth quarter of 2010.
Two months ago, expectations had been for a 10% to 12% gain in fourth quarter earnings. Actual fourth quarter earnings are thus coming in lower than what recently had been expected. The quarter is also coming in lower than the first three quarters of 2011.
Earnings growth in 2011 was 19% in the first quarter, 12% in the second quarter, and 18% in the third quarter. The fourth quarter will thus be the first, sub-double-digit quarter of the year.
The slowdown in earnings was inevitable. Strong earnings gains in 2010 and 2011 were the result of improvement from low profit levels following the recession of 2008-9. Companies improved efficiency by keeping costs under control as revenue rebounded in 2010 and 2011, but profit margins can only rise so high.
Even with strong international revenue growth for many S&P 500 companies, the sluggish revenue growth trends in the U.S. dictate that profit growth had to slow.
The slowdown is expected to continue into 2012.
Wall Street forecasts for 2012 earnings growth center around 5% for the first quarter of 2012, followed by 10% growth in the second quarter, 5% in the third quarter, and 15% in the fourth quarter of 2012.
Those quarterly increases would create an overall earnings gain for calendar year 2012 of about 9%, down from 14% for 2011, and 40% for 2010 (as earnings rebounded from the devastation of 2008 and 2009).
The forecast of 9% earnings growth for 2012 overall may even be too high. Wall Street tends to overestimate earnings a few quarters out, and for 2012 a strong rebound in financial company profits is expected in the second half of the year. If that does not materialize, earnings growth in 2012 could be closer to a 5% to 7% range.
This slowdown in earnings growth, however, does not alter our view on the positive relative value of stocks.
Valuations
The price/earnings multiple on the S&P (assuming fourth quarter earnings come in at 8%) is a very reasonable 13.5.
That is low compared to historical standards, reflecting very good value.
The value is even more apparent when compared to alternative investments.
That 13.5 P/E is equivalent to a 7.4% earnings yield (E/P).
A 7.4% earnings yield, compared to the paltry 1.8% available on 10-year Treasury notes, is extremely attractive.
That value remains compelling even if earnings only grow at a 5% rate in 2012.
One way to look at this is that earnings rose 14% in 2011 and the stock market was flat. In effect, that leaves substantial underlying upside potential from earnings even with only modest earnings growth in 2012.
The stock market was held back in 2011 due to continued concerns about the global economic and credit market outlook.
If those conditions do not worsen from current expectations, the stock market can continue its three-year rally on the back of modest earnings growth. There is substantial pent-up value in stocks which can be realized even without double-digit earnings growth.
What It All Means
The slowdown in earnings growth in the fourth quarter is more severe than either Wall Street or Briefing.com had expected. It isn't, however, all that surprising given global economic conditions. And even 8% earnings growth for the fourth quarter of 2011 is very solid and fully justifies current stock market valuations.
A further slowdown in earnings in 2012 is likely, but the slowdown won't be to the degree that would prevent the S&P from rising this year. Valuations are so low, with a very attractive 7.4% earnings yield, that almost any earnings growth at all would produce investment opportunities in stocks.
Last year, Briefing.com's theme of investing in high-quality, high dividend yield stocks paid off. For example, the Dogs of the Dow produced a 17% return in 2011.
Even at a slower growth rate, the earnings trends are strengthening corporate balance sheets and producing tremendous cash flow. That will leave plenty of room for dividend increases from the already healthy 2.1% dividend yield on the S&P 500.
A focus on high-quality, high-dividend yield stocks in 2012 remains attractive, despite the understandable earnings slowdown which is now occurring.
