2Q09 Earnings Season: So Far, So Good…

…but still too early to ring the bullish bell.

As earnings season begins in earnest and will soon kick into high gear, the fundamental valuation proof for equity prices’ faith (since early March) in an improved corporate profitability environment is the central issue at hand for investors. To justify current prices, second quarter earnings results MUST demonstrate that companies can turn in profits above consensus earnings expectations in an overall weak economic environment.

If 2Q09 results come in above consensus estimates (which are around $14 operating earnings for the S&P 500 - see table to your left), then stocks have a solid leg to stand on from which higher prices can follow as the second half of the year unfolds. Such a performance would signal that companies are able to produce sound earnings growth and profitability from the global economy while developed economies, such as the US, struggle with recessions followed by below potential growth.

Operating efficiencies, enhanced by recessionary-induced cost cutting, coupled with exposure to developing economies (which is where the global growth is and will be for the foreseeable future) are the ingredients for the potential of above consensus earnings results.

Conversely, should the numbers in the quarter just ended come in at or below consensus expectations, then concerns re valuation are justifiable. The valuation math in the near term is therefore not encouraging for the bullish case. To illustrate, take a moment to review the above table from this week’s “Sectors and Styles Strategy Report”.

The operating estimates for the S&P 500 for 2009 are in the mid $50 range. With the index at 900, that produces a 16.4 times P/E. Given the fact that the historical P/E for the S&P 500 in normal times is 15, it is hard to get overly enthusiastic for stocks with an above average P/E in less than normal times - which then brings into play the economic weeds that seem to be flourishing among the so-called green shoots.

Investment Strategy Implications

If companies cannot produce above consensus results (via global growth and operating efficiencies) and given the fragile state of the US economy, the suggestion is that the economic weeds that may strangle the US may also inhibit corporate growth and profitability such that earnings results will not justify even an average P/E.

The earnings results issued from several high profile names is, thus far, encouraging. However, as is the case with the technical analysis of stocks and the incomplete bottoming process, investors are well served to see how this plays out over the coming weeks as the earnings season provides more clarity on corporate profitability and the valuation justification for higher stock prices.